Contango

Contango is a term used to describe the structure of prices in the market across the time horizon, and is most often associated with commodities and futures markets.

In a contango market, the futures price is higher than the expected spot price of the underlying asset at the contract's expiration. That means a futures contract will trade at a premium to the spot price.

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).

For example, silver futures markets often trade in contango—meaning prices are projected to increase the further one goes out on the time horizon.

The opposite of a contango market is known as “backwardation.” In backwardation, the futures price is lower than the expected spot price of the underlying asset at the contract's expiration. That means the futures contract trades at a discount to the spot price.

In a normal market, longer-dated futures contracts are priced higher than current spot prices, due to inflation and the risk of other unknown market factors that may develop over time.

Markets may also trade in contango because the asset or commodity in question has associated carrying costs, or storage costs. Contango markets are generally associated with adequate supply and efficiency, as well as low price volatility. However, that may not always be the case.

Markets tend to move into backwardation when there’s widespread agreement that an asset’s current price will decline in the future. For example, if an economic recession is expected to develop, markets may go into backwardation to account for slowing demand, which often has a negative impact on price.

Supply disruptions, weather events, and geopolitical events can also contribute to backwardation.

The spot price refers to the current price for immediate delivery, while the futures price refers to the price at which a futures contract for an asset can be bought or sold.

A futures contract is a standardized agreement to buy or sell an asset (such as commodities, currencies, or financial instruments) at a predetermined price on a future date. 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.

The futures price typically differs from the spot price due to a variety of factors, including supply/demand, interest rates, storage costs, market sentiment, and market participants' outlook on the asset's future value.

Generally speaking, the natural state of most markets is contango—when prices gradually rise over time.

In a normal market, longer-dated futures contracts are priced higher than current spot prices, due to inflation and the risk of other unknown market factors that may develop over time.

That means contango markets are generally associated with adequate supply and efficiency, as well as low price volatility. However, that may not always be the case.

On the other hand, markets tend to move into backwardation when there’s widespread agreement that an asset’s current price will decline in the future. For example, if an economic recession is expected to develop at some point in the future, the market may go into backwardation to account for slowing demand, which often has a negative impact on price.

Supply disruptions, weather events, and geopolitical events can also contribute to backwardation in markets.

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.

In this scenario, the one-month futures contract might be priced at $72 per barrel, while the six-month futures contract might be priced at $75 per barrel. This price difference between the contracts reflects the cost of storing the oil and other factors such as interest rates and future market expectations.

As a result, the market is said to be in contango because the future prices of oil are higher than the spot price.

Contango markets are generally associated with adequate supply and efficiency, as well as low price volatility. These conditions may be beneficial to traders that want to avoid fast-moving markets that can experience sudden (and sometimes dramatic) price changes.

Markets in backwardation, on the other hand, can experience heightened volatility due to supply disruptions, geopolitical events, or sudden changes in sentiment.

Price fluctuations can occur swiftly in backwardation, potentially leading to increased risk and significant capital losses. Investors and traders should therefore be prepared for heightened volatility in backwardation, and have appropriate risk management controls in place.

That said, contango markets may also experience sharp price changes due to unexpected developments in the market. For this reason, investors and traders should adhere to disciplined risk management practices in all market environments, as contango can flip to backwardation, and vice versa at any time.

There’s no guaranteed method of profiting from a contango market, just as there’s no guaranteed method of profiting from a market in backwardation.

Moreover, the investing/trading approach adopted in any market environment will depend heavily on a given investor/trader’s outlook and risk profile.

However, investors and traders can consider several different approaches in a contango market to try and make a profit—assuming one of the strategies fits the investor/trader’s outlook and risk profile.

In a contango market, an investor/trader might engage in a spread if he/she believes that prices will fall in the future. To execute the spread, the investor/trader would buy a near-term futures contract in favor of selling a longer-dated futures contract.

If the prices of the contracts converge over time, a futures spread of this type will generally produce a profit. But if the prices in the spread diverge, it will create a loss.

Contango markets may also offer opportunities for physical products vs futures contracts trades. For example, by purchasing the physical commodity at the current spot price, and locking in a profit by selling a futures contract at a higher price. However, this approach will hinge on associated carrying/storage costs, and other market factors.

Trading in physical commodities and commodities futures can be complex, which is why investors and traders need to do extensive research prior to entering a position.

In a contango market, the futures price is higher than the expected spot price of the underlying asset at the contract's expiration. This means that the futures contract trades at a premium to the spot price.

For example, the majority of the time, crude oil futures markets trade in contango—meaning prices are projected to increase the further one goes out on the time horizon.

In backwardation, the futures price is lower than the expected spot price of the underlying asset at the contract's expiration. That means the futures contract currently trades at a discount to the spot price.

• In a contango market, the futures price is higher than the expected spot price of the underlying asset at the contract's expiration. That means a futures contract will trade at a premium to the spot price.
• 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).
  • For example, crude oil futures markets often trade in contango—meaning prices are projected to increase the further one goes out on the time horizon.
• The opposite of a contango market is a market in “backwardation.” In backwardation, the futures price is lower than the expected spot price of the underlying asset at the contract's expiration. That means the futures contract trades at a discount to the spot price.