Contango

What Is Contango?

Contango is a situation where the futures price of a commodity is higher than the spot price. Contango generally happens when an asset price is expected to rise after some time. That outcomes in a vertical slanting forward curve.

Grasping Contango

Futures contract supply and demand influence the futures price at each available expiration. In contango, investors will pay something else for a commodity later on. The premium over the current spot price for a specific expiration date is typically associated with the cost of carry. Cost of carry can incorporate any charges the investor would have to pay to hold the asset throughout some undefined time frame. With commodities, the cost of carry generally incorporates storage costs and depreciation due to spoiling, decaying, or decay now and again.

In all futures market situations, the futures prices will typically join toward the spot prices as the contracts approach expiration. That happens on account of the large number of buyers and sellers in the market, which makes markets efficient and disposes of large opportunities for arbitrage. In that capacity, a market in contango will see slow declines in the price to meet the spot price at expiration.

Generally, futures markets include a substantial amount of speculation. At the point when contracts are further away from expiration, they are more speculative. There are a couple of purposes behind an investor to lock in a higher futures price. As referenced, the cost of carry is one common justification for buying commodities futures.

Producers have different motivations to pay more for futures than the spot price, subsequently making contango. Producers make commodity purchases depending on the situation in view of their inventory. The spot price versus the futures price might be a factor in their inventory management. Notwithstanding, they will generally follow the spot and futures prices while seeking to accomplish the best cost productivity. A few producers might accept that the spot price will rise as opposed to fall after some time. In this manner, they hedge with a marginally higher price from here on out.

Contango versus Backwardation

Contango, now and again alluded to as forwardation, is something contrary to backwardation. In the futures markets, the forward curve can be in contango or backwardation.

A market is "in backwardation" when the futures price is below the spot price for a specific asset. As a rule, backwardation can be the consequence of current supply and demand factors. It could be signaling that investors are anticipating that asset prices should fall over the long run.

A market in backwardation has a forward curve that is descending slanting, as displayed below.

Benefits and Disadvantages of Contango

Benefits of Contago

One method for benefitting from contango is through arbitrage strategies. For instance, an arbitrageur could buy a commodity at the spot price and afterward promptly sell it at a higher futures price. As futures contracts close to expiration, this type of arbitrage increases. The spot and futures price really merge as expiration approaches due to arbitrage, and contango reduces.

There is likewise one more approach to profiting from contango. Futures prices over the spot price can be a signal of higher prices from here on out, especially when inflation is high. Examiners might buy a greater amount of the commodity encountering contango trying to profit from higher expected prices from now on. They could possibly get even more cash-flow by buying futures contracts. In any case, that strategy possibly works assuming genuine prices in the future surpass futures prices.

Involving Contango May Not Be for You

Endeavoring to profit from contango frequently implies facing challenges that are not fitting for most individual investors.

Weaknesses of Contango

The main weakness of contango comes from consequently rolling forward contracts, which is a common strategy for commodity ETFs. Investors who buy commodity contracts when markets are in contango will quite often lose some money when the futures contracts terminate higher than the spot price.

Luckily, the loss brought about by contango is limited to commodity ETFs that utilization futures contracts, like oil ETFs. Gold ETFs and different ETFs that hold genuine commodities for investors don't experience the ill effects of contango.

Highlights

• Contango is a situation where the futures price of a commodity is higher than the spot price.
• In all futures market situations, the futures prices will ordinarily merge toward the spot prices as the contracts approach expiration.
• Advanced traders can utilize arbitrage and different strategies to profit from contango.
• Contango will in general reason losses for investors in commodity ETFs that utilization futures contracts, however these losses can be tried not to by buy ETFs that hold genuine commodities.

FAQ

What Are the Causes of Contago?

Contango can be brought about by several factors, including inflation expectations, expected future supply disturbances, and the carrying costs of the commodity being referred to. A few investors will try to profit from contango by taking advantage of arbitrage opportunities between the futures and spot prices.

How Does Contango Affect Commodity Exchange-Traded Funds (ETFs)?

It is important for investors in exchange-traded funds (ETFs) to comprehend how contango can influence certain commodity-based ETFs. In particular, on the off chance that a commodity ETF puts resources into commodity futures contracts rather than genuinely holding the commodity being referred to, that ETF might be forced to constantly supplant — or "turn over" — its futures contracts as its more seasoned contracts terminate. On the off chance that the commodity being referred to is subject to contango, this would lead to a consistent rise in the prices being paid for these futures contracts. Long term, this can essentially increase the costs brought into the world by the ETF, putting a descending drag on the returns earned by its investors.

What Is the Difference Between Contango and Backwardation?

Something contrary to contango is known as backwardation. At the point when the market is in backwardation, the futures prices for the commodity follow a descending slanting curve where futures prices are below spot prices. In spite of the fact that backwardation is somewhat rare, it really does sometimes happen in several commodity markets. Reasons for backwardation remember anticipated declines for demand for the commodity, expectations of deflation, and a short-term shortage in the commodity's supply.