Understanding Contango
By Carl Loffmark
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What is contango?
Contango refers to the price structure of the futures market when the futures contract is at a premium to the spot price. Under normal conditions when the supply of a commodity is abundant, the futures market incorporates a higher price to reflect the cost-of-carry to store a commodity into the future.
Why is the futures price higher than the spot?
A successful futures trading strategy requires an understanding of the factors that influence the futures price into contango. In a contango market, the amount of premium the futures contracts may carry over the spot price is impacted by storage-related costs such as: interest rates, insurance, rent, taxes, etc. The higher the overall costs, the higher the contango may be. When supplies of a commodity are more than adequate to meet demand, the market will incorporate a level of contango that accurately reflects the full cost-of-carry.
What are the effects of supply and demand?
Contango puts buyers at a significant disadvantage because they must purchase the futures contract at a premium to the spot price. Under this scenario, buyers are effectively required to pay the storage cost premiums built into the higher contango futures price, so as time goes by, and if the spot price remains unchanged, the futures price will decline until it eventually converges with the lower spot price. The buyer must overcome this burden, whereas the seller benefits.
A real world example.
The contango curve may steepen (widen) beyond full cost-of-carry, especially in the nearby part of the curve if supplies are plentiful enough, and demand weakens enough, to cause a glut in the market. A glut may pressure the price of the nearby contract down more than the deferred contract, steepening the front end of the contango curve.
An example of this occurred shortly after the start of the COVID pandemic, when there was a collapse in demand for crude oil. Owning crude oil became a huge liability as supply temporarily overwhelmed demand and owners were required to pay storage costs for items such as ocean freighters and railcars loaded with crude oil that nobody wanted. The nearby future contract became negatively priced and the contango at the front end of the curve was much steeper than ever, as the distant contracts did not decline as much. The steep slope of the contango curve at the front end reflected the glut in the spot price.
How to profit in a contango market.
A widening contango is a bearish influence and a narrowing contango is a bullish influence, assuming cost-of-carry remains constant. Buyers in a contango market should always purchase the most active nearby futures contract in order to benefit from the possibility of the contango spread narrowing.
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