What is Contango? (Beginners Guide)

When you first step into the world of futures trading, you’ll encounter various terms and concepts that might seem confusing at first. One such concept is contango, a term that often comes up in discussions about commodity markets and futures contracts. Understanding contango is crucial for anyone looking to trade or invest in futures, as it can significantly impact the profitability of your trades. In this comprehensive guide, we’ll break down what contango is, how it works, why it occurs, and its implications for traders and investors.

What is Contango?

Contango is a situation in the futures market where the price of a futures contract is higher than the expected future spot price of the underlying asset. In simpler terms, it’s when the futures price is higher than the current spot price. This creates an upward-sloping forward curve, meaning that futures contracts with later expiration dates are priced higher than those with earlier expiration dates.

For example, if the current spot price of oil is $60 per barrel, but the futures price for delivery in six months is $65 per barrel, the market is said to be in contango.

Why Does Contango Occur?

Contango typically occurs in markets where there are costs associated with holding the underlying asset over time. These costs might include storage, insurance, and financing costs. Let’s explore some of the main reasons behind contango:

• Storage Costs: When dealing with physical commodities like oil or wheat, there are costs involved in storing the asset until it’s delivered. These costs are often passed on to the futures price, causing later-dated contracts to be more expensive than the current spot price.
• Interest Rates: Holding a commodity or financial asset over time incurs an opportunity cost, as the money used to purchase it could have been invested elsewhere to earn interest. Higher interest rates can lead to higher futures prices.
• Insurance Costs: For physical commodities, there may be insurance costs associated with protecting the asset during storage. These costs are factored into the futures price.
• Supply and Demand Expectations: If the market expects the supply of a commodity to increase or demand to decrease in the future, the futures price may be higher than the current spot price to account for this anticipated change.

Example of Contango in Action

Let’s take a closer look at a hypothetical example to understand contango:

Suppose the current spot price of crude oil is $70 per barrel. A trader looks at the futures market and sees the following prices for oil futures contracts:

• 1-Month Futures Contract: $71 per barrel
• 3-Month Futures Contract: $72 per barrel
• 6-Month Futures Contract: $73 per barrel

In this scenario, the market is in contango because the futures prices are higher than the current spot price, and the prices increase with longer timeframes.

If you were to buy a 6-month futures contract at $73 per barrel, you would be betting that the spot price of oil will rise above $73 by the time the contract expires. If the spot price remains at $70 or falls, you would incur a loss.

Contango vs. Backwardation

To fully understand contango, it’s essential to compare it with its opposite, backwardation. In backwardation, the futures price is lower than the expected future spot price. This creates a downward-sloping forward curve, meaning futures contracts with later expiration dates are cheaper than those with earlier dates.

Backwardation typically occurs when there is a high demand for the asset in the short term or when there is a shortage of supply. In this case, traders are willing to pay a premium for immediate delivery, causing the spot price to be higher than the futures price.

In summary:

• Contango: Futures prices are higher than the spot price; the forward curve slopes upward.
• Backwardation: Futures prices are lower than the spot price; the forward curve slopes downward.

Implications of Contango for Traders and Investors

Understanding contango is crucial for traders and investors because it can have a significant impact on the profitability of certain trading strategies, especially in the context of commodities and exchange-traded products (ETPs) like ETFs and ETNs that track futures indices.

• Impact on Commodity ETFs: Many commodity ETFs use futures contracts to track the price of an underlying commodity. When the market is in contango, the fund may have to sell lower-priced contracts and buy higher-priced contracts as they roll over their positions to maintain exposure. This can lead to a phenomenon known as “negative roll yield,” where the ETF loses value over time even if the spot price of the commodity remains unchanged.
• Impact on Futures Traders: For futures traders, contango can make it challenging to profit from holding long positions in futures contracts over time. As the futures price converges to the spot price at expiration, traders in a contango market may see their gains eroded by the higher futures prices they initially paid.
• Arbitrage Opportunities: In some cases, traders may attempt to exploit contango through arbitrage strategies. For example, if they believe the futures price is too high relative to the expected future spot price, they might short the futures contract and buy the underlying asset in the spot market. However, such opportunities are often limited and require sophisticated trading strategies.

Contango in the Oil Market

The oil market provides a real-world example of how contango can play out. Oil prices are subject to various factors, including geopolitical events, supply and demand dynamics, and storage capacity.

During periods of oversupply, when there is more oil available than there is demand, the market often enters contango. This happened in 2020 when the COVID-19 pandemic led to a collapse in oil demand while supply remained relatively high. The result was a steep contango, where the cost of storing oil became a significant factor in the futures market.

Oil companies and traders faced challenges as the cost of holding and storing oil increased, leading to higher futures prices. For investors in oil ETFs that track futures, this contango created a negative roll yield, resulting in losses even as oil prices began to recover.

How to Navigate Contango?

If you’re a trader or investor dealing with futures or commodity-linked products, here are some tips for navigating contango:

• Understand the Roll Yield: If you’re investing in commodity ETFs or ETNs, be aware of how contango can impact the roll yield. Research the fund’s strategy and historical performance during contango periods to gauge the potential risks.
• Monitor the Forward Curve: Keep an eye on the forward curve of the commodity or asset you’re trading. Understanding the shape of the curve can help you anticipate how contango might affect your positions.
• Consider Alternative Strategies: If you’re concerned about the effects of contango, explore alternative strategies that might mitigate its impact. For example, you might consider options trading, using inverse ETFs, or focusing on assets that are less affected by storage costs and interest rates.
• Stay Informed: Contango can be influenced by a variety of factors, including macroeconomic conditions, geopolitical events, and changes in supply and demand. Stay informed about market developments that could impact the futures market.

Conclusion

Contango is a fundamental concept in futures trading that can have significant implications for traders and investors. While it might seem complex at first, understanding contango is essential for anyone involved in markets where futures contracts are traded.

By recognizing the factors that lead to contango and understanding its impact on trading strategies and investment products, you can make more informed decisions and better navigate the challenges of the futures market. Whether you’re trading oil futures, investing in commodity ETFs, or exploring other markets, a solid grasp of contango will help you manage risk and improve your trading performance.