Definition
Backwardation and Contango are terms used to describe the futures market. Backwardation is when futures prices are lower in the distant delivery months than in the nearest delivery month, indicating a tight supply and high demand for the underlying asset. Contango is the opposite, it happens when futures prices are higher in the distant delivery months than in the nearest delivery month, often due to high supply or low demand for the underlying asset.
Key Takeaways
- Backwardation and contango are terms used to describe the shape of the futures curve. Backwardation occurs when futures prices are lower in the distant delivery months than in the near delivery months, while contango is when futures prices are higher in the distant delivery months.
- Backwardation is a market condition where there’s a high demand for spot delivery or there’s a cost of carry, such as storage costs. It’s often seen in commodities markets where users need the product immediately. On the other hand, contango often occurs when the underlying asset has no carry costs and there’s an expectation of price increase over time.
- In investing strategies, backwardation can be profitable for investors who enter into futures contracts and hold them to expiration, as they may be able to buy at a lower price and sell at a higher spot price later. Conversely, contango can be unfavorable for long-term futures contract holders as they might have to buy high now and sell low in the future.
Importance
Backwardation and Contango are significant terms in finance because they offer insight into the condition and future expectations of the market, specifically regarding futures contracts.
Backwardation occurs when futures prices are lower than the spot price, suggesting higher demand for immediate delivery or a negative sentiment about future price movements.
On the other hand, Contango refers to the situation where futures prices are higher than the spot price, implying the costs of storing and holding the asset until delivery outweigh short-term gains or positive sentiment about future price increases.
Understanding these two concepts is crucial for investors as it helps to inform trading decisions, mitigate risk and take advantage of arbitrage opportunities.
Explanation
Backwardation and Contango are both terms used to describe the shape of the futures curve and give insight into market expectations of future price movements. They are significant in that they influence decision-making processes among investors trading in futures markets. Understanding the conditions of backwardation and contango can be pivotal for investors or companies who are either seeking to hedge against price risks or take advantage of potential profit opportunities in future contracts.
Backwardation is a scenario where futures prices are lower than the spot price. This typically occurs when the demand for an asset today is higher than its anticipated future price. It can signal market expectation of falling prices.
From an investor’s point of view, backwardation can present an opportunity to buy future contracts at a lower price than the current market price. Conversely, contango is a situation where futures prices are higher than the spot price, implying that market participants expect prices to rise over time. This presents an opportunity for those who seek to sell a futures contract for a higher price than the current spot price, and take advantage of the anticipated price increase in the future.
In both situations, individuals and companies use these different market conditions to better manage risk and make more informed investment decisions.
Examples of Backwardation vs Contango
Crude Oil Market: During the financial crisis in late 2008, the global oil market was in a contango state, where future prices were higher than the spot prices. This was due to the low demand and high supply of oil, leading investors to anticipate price increases in the future. Contrarily, in mid-2014 the oil market entered backwardation due to political instability in the Middle East, causing future oil prices to be lower than the spot price with the expectation of increased supply in the future.
Gold Market: In the gold market, backwardation is a rare phenomenon given gold’s status as a safe haven commodity. This occurs when holders of gold prefer to hold onto their physical gold rather than lend it out. However, in February 2001, Gold was in a backwardation for a brief period due to concerns about the financial stability of major economies. On the other hand, the gold market generally exhibits contango, where future Gold prices are higher than the spot prices, encouraging gold producers to sell their gold forward.
Natural Gas Market: The natural gas markets often experience both contango and backwardation. In winters, when demand for heating is high, natural gas markets can enter backwardation as the current demand (spot prices) often exceeds future expectations. During summers, when demand is low, the market can move into contango, as future prices may exceed spot prices with expectations of increased demand in the winter months.
FAQs: Backwardation vs Contango
What is Backwardation?
Backwardation refers to a market situation where the price of a commodity’s forward or futures contract is trading below the expected spot price at contract maturity. This typically happens when the market anticipates a decrease in the commodity’s price over time.
What is Contango?
Contango is the opposite of Backwardation. It is a situation where the price of a commodity’s forward or futures contract is trading above the expected spot price at contract maturity. This usually happens when the market expects a rise in the commodity’s price over time.
What causes Backwardation and Contango?
Backwardation can be caused by a short-term supply shortage, high carrying costs, or high demand for the commodity. Contango, on the other hand, can be caused by factors like low storage costs, surplus supply, or low spot prices.
How do Backwardation and Contango affect traders?
In Backwardation, since futures prices are lower than spot prices, traders could potentially sell the commodity at a higher spot price now and buy it back later at a lower future price, profiting from the difference. In Contango, traders might buy futures contracts at a lower price now and sell them at a higher price in the future.
Can a market switch between Backwardation and Contango?
Yes, a market can switch between Backwardation and Contango based on changes in supply and demand, carrying costs and various other factors. A comprehensive understanding of these dynamics helps traders to predict future price movements and trade accordingly.
Related Entrepreneurship Terms
- Future Contracts: A financial contract obligating the buyer to purchase an asset (or the seller to sell an asset) at a predetermined future date and price.
- Spot Price: The current market price at which an asset, like a commodity, is bought or sold for immediate delivery and payment.
- Forward Curve: In finance, the forward curve is a graphical representation of the prices of futures contracts for different time horizons. It shows the expected values at different points in the future.
- Carry Costs: The costs associated with storing and financing a commodity or financial instrument until it is sold. In commodity markets, storage costs can play a crucial role in determining future prices.
- Commodities: A basic good used in commerce that is interchangeable with other goods of the same type. Commodities are frequently bought or sold in futures contracts, where backwardation and contango can be observed.
Sources for More Information
- Investopedia – A comprehensive online resource for everything related to finance and investing, providing in-depth definitions and explanations of both terms: backwardation and contango.
- Bloomberg – A global leader in business and finance news, Bloomberg offers detailed articles and reports about various financial topics, including backwardation and contango.
- CNBC – As a leading business news website, CNBC provides news, analysis and opinion on top stories, stock markets, finance and economy.
- Econlib, The Library of Economics and Liberty – A free online resource that promotes economic education and debate. It provides comprehensive insights into all things economics, including in-depth discussions of concepts such as backwardation and contango.
