Contango is normal for a non-perishable commodity that has a cost of carry. One of those potential risks is called contango, and it has to do with the relationships between different futures contracts on the same product. Many ETFs have fallen prey to the negative long-term impact of contango, but unless you know what it is, you won’t necessarily recognize whether an ETF is using an investment strategy that puts you at risk. If you have commodity ETFs in your portfolio, contango could hurt their value. You could make trades in the futures market because other investors seem to expect ongoing contango.
Over the ensuing months, the economy regains its footing and the spot price of oil starts to rally back up to the long-term price of $70 per barrel. The refining company, by contrast, gets to keep running through its inventory of $40 oil, locking in fat profit margins for the year. Investors run into new concepts all the time, and to be successful with your investments, you have to understand all the factors that can affect your portfolio and its holdings. Those who invest primarily in stocks typically know the ins and outs of the businesses in which they own shares along with the risks they face.
Physical commodity traders may seek to store millions of barrels on oil tankers. Futures contracts for oil are settled by physical delivery of the oil. As a practical matter, most physically settled futures contracts are offset in the market before going to the delivery stage. A futures contract is a derivative that allows traders to buy an asset at the predetermined price. When at contango, a futures contract trades at a higher price than the commodity’s current price. A market is in contango when a commodity/financial asset’s futures prices are rising above its current spot price, creating an upward sloping price curve.
Investing in futures contracts — or in the exchange-traded funds that themselves have holdings in futures contracts — can expose you to some risks that you’ve never heard of before. A disadvantage of contango would be the automatic rolling forward of contracts, which can lead traders to incur losses when a futures contract expires at a higher price than the spot price of the commodity. Investors in commodities funds that hold futures contracts will hear or read https://1investing.in/ the words contango and backwardation. The terms are apt to confuse even those with some Wall Street experience, but understanding them is vital for investors in commodities. Over time, the futures price and the spot price of a commodity converge at the expiration date of the contract as the risk and the remaining cost of carry diminishes. In this article, we’ll lay out the differences between contango and backwardation and show you how to avoid serious losses.
In the event that the price is at $0 for a given month, as oil was in 2020, this could potentially destroy a fund as it would have no capital with which to buy the next month’s futures. Some oil funds were restructured following that incident to attempt to lower risk of a blow-up event in the future. The market is said to be in a state of contango when traders are willing to pay less for a commodity today than they are at a later date. If the futures prices show a rising slope with a price of, say, $2000 to buy an ounce of gold five years from now in the futures market, that would be contango. The opposite of this, backwardation, is when prices are higher today than in the future. A market is “in backwardation” when the futures price is below the spot price for a particular asset.
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Backwardation describes a downward sloping curve where the prices for future delivery are lower than the spot price (e.g., the price of oil delivered in 3 months is $40/bbl and the spot price is $50/bbl). One of the most common markets that see contango is the crude oil futures market. It experienced contango in 2020—the Organization of the Petroleum Exporting Countries (OPEC) called it super contango, meaning that the difference between futures and spot prices was very pronounced. Futures contract supply and demand affect their price at each available expiration. Contracts represent a specified amount of a commodity to be delivered at a certain date, called the expiration date, and other specifications.
When trading in commodity futures, you agree to buy or sell the asset at a predetermined price at a specific time in the future. Contango is the industry term for when the futures price of a commodity is higher than the current price. A crude oil contango occurred again in January 2009, with arbitrageurs storing millions of barrels in tankers to profit from the contango (see oil-storage trade). Investors in exchange-traded funds (ETFs) must understand how contango can affect certain commodity-based ETFs.
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What is contango?
This creates a downward sloping curve for futures prices over time relative to the current spot price. However, certain instruments like VIX products and leveraged ETFs state the objective is to mirror the “one-day performance” of the underlying index or commodity. Usually, this done synthetically buying and selling the futures contracts.
They also factor in a premium above the current (or spot) price of a commodity to account for risk and the cost of carrying the commodity. Cost of carry can include the expenses related to holding onto the commodity, such as theft, storage costs and depreciation, due to spoilage, rotting or decay. For example, an arbitrageur might buy a commodity at the spot price and then immediately sell it at a higher futures price. As futures contracts near expiration, this type of arbitrage increases. The spot and futures prices actually converge as expiration approaches due to arbitrage. In a contango market, the futures price is higher than the expected spot price of the underlying asset at the contract’s expiration.
- There are also a wide range of future prices, which are what investors and companies are willing to pay for delivery of a commodity at different times in the future.
- In a contango situation, the forward price of a commodity’s futures contract will be higher than its spot price.
- Some oil funds were restructured following that incident to attempt to lower risk of a blow-up event in the future.
- The opposite of contango is backwardation, when futures prices are lower than spot prices.
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This type of arbitrage occurs more frequently as futures contracts near expiration. The opportunity quickly disappears, however, because spot prices and futures prices converge as the contract expiration approaches. A contango market is also known as a normal market, or carrying-cost market.
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A market is considered in backwardation when the forward price of a futures contract is lower than the spot price of the commodity. Contango and backwardation are vital concepts for anyone wishing to trade commodity futures directly, or invest in exchange-traded funds based on these underlying commodity futures. By understanding these concepts and knowing what impact they will have on commodity investments, it should help investors stay on the right side of the market.
The futures price is determined through the interaction of buyers and sellers in the futures market, and it represents the market’s expectation of the asset’s value at the contract’s expiration. Contango is when the futures price is above the expected future spot price. Because the futures price must converge on the expected future spot price, contango implies futures prices are falling over time as new information brings them into line with the expected future spot price.
The existence of this Marketing Agreement should not be deemed as an endorsement or recommendation of Marketing Agent by tastytrade. Tastytrade and Marketing Agent are separate entities with their own products and services. The gold market may therefore trade in contango or backwardation, much like any other commodities market.
Contango Meaning, Why It Happens, and Backwardation
Another opportunity for investors to profit from contango is the inflation signals of the commodities market. Inflation often starts at basic goods and raw materials within the economy. It then flows upward into more complex and finished goods that are purchased by consumers and businesses. Understanding that inflation is taking hold can signal impacts to other areas of the market that the investor can use to their advantage. To profit from this advance knowledge, an investor may exit other positions that could be hurt by rising prices.
- Futures markets are in a state of contango approximately 80% of the time.
- Volatility profiles based on trailing-three-year calculations of the standard deviation of service investment returns.
- Investors trade in commodities as a way to diversify their portfolios and take advantage of the price fluctuations of goods.
- Both care about whether commodity futures markets are contango markets or normal backwardation markets.
Going back to the example, the trader will sell a futures contract for delivery two months out at $65 while also purchasing enough barrels at spot price of $60 to later fulfill the order. By locking in that profit at the higher price, and then sitting on the physical oil for a couple of months, a trader can realize substantial gains. On a full-size oil futures contract, that would represent a profit of around $5,000 for merely storing the oil for a couple of months.
How Does Contango Affect Commodity Exchange-Traded Funds (ETFs)?
These scenarios create opportunities for investors to generate a profit by taking advantage of the market dislocations. This action also simultaneously helps to bring spot prices and futures contracts back into alignment. Investors trade in commodities as a way to diversify their world’s largest salt mine portfolios and take advantage of the price fluctuations of goods. Commodities are broadly categorized as one of four types – metal, energy, livestock and meat and agricultural. You can invest in commodities through futures contracts, options and exchange-traded funds (ETFs).
With so much oil for so little demand, the spot price of oil fell below zero. Suppliers had to pay companies to buy oil to make up for their storage costs. The futures prices of oil were much higher showing conditions were expected to rebound.
Exchange-traded funds (ETFs) provide an opportunity for small investors to participate in commodity futures markets, which is tempting in periods of low interest rates. The money raised from the low priced, closed out contracts will not buy the same number of new contracts going forward. Looking at an example, imagine crude oil is currently trading $70 per barrel (for immediate delivery). In a contango market, longer-dated futures contracts will be priced higher than near-term futures contracts. Futures contracts investors expect to buy or sell commodities at a fixed price on a specific date in the future. When prices are higher, this creates contango and when they are lower, that is known as normal backwardation.
Supporting documentation for any claims (including claims made on behalf of options programs), comparisons, statistics, or other technical data, if applicable, will be supplied upon request. Tastylive is not a licensed financial adviser, registered investment adviser, or a registered broker-dealer. Options, futures, and futures options are not suitable for all investors. These exchange-traded funds don’t own physical assets—they take up too much space and have a high cost of carry. Instead, they track commodity prices by rolling over short-term futures contracts. They sell existing positions as they gets close to expiring and buy again at the new price.
In all futures market scenarios, the futures prices will usually converge toward the spot prices as the contracts approach expiration (expiry). That happens because the expiry date is drawing closer and is more reflective of the actual value of the commodity—contract traders are going to pay closer and closer to the spot market values. Additionally, because there is a large number of buyers and sellers, the market becomes more efficient and eliminates large arbitrage opportunities. Tastylive content is created, produced, and provided solely by tastylive, Inc. (“tastylive”) and is for informational and educational purposes only. Trading securities, futures products, and digital assets involve risk and may result in a loss greater than the original amount invested. Tastylive, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations.
Commodities prices are set by investors buying and selling contracts for the delivery of raw materials now and in the future. When prices for a given commodity are lower for delivery today than they are for delivery in the future, it’s called contango. Commodities traders buy and sell these contracts on commodities exchanges. Buyers place bids to purchase the contracts, some of which will take physical possession of the commodities. These contracts represent commodities that will be delivered in the future, so their price is what traders believe the contracts will be worth when they reach their expiration date. Contango markets describe the “normal” state of most markets, because in the majority of instances asset prices are expected to rise over time (due to inflation and other market factors).