Contango and Backwardation

Introduction to Contango and Backwardation

You must have visited so many websites to get a gist of contango and backwardation, but at the end of your search, what do you get in your hand? You may get more confused and may start banging your head, thinking that the concept of Contango and Backwardation is complex. So please don’t bang your head; just read this article carefully. This article will provide quality food to your brain, and at the end of this article, you will become a master of contango and backwardation.

Let’s assume that you are a trader in the commodity market and you are dealing with various hard and soft commodities.

As a trader in a commodity market, you may encounter various market situations like contango and backwardation that may hassle your mind. Like before the war; soldier prepares themselves for battle; they understand various situations of battle and act accordingly; Likewise, as a trader; you must have aware of different market situations like Contango vs backwardation to make money for the client and yourself.

Concepts of Contango and Backwardation

Before swimming in the river of Contango and backwardation, let’s wear some lifesaving concepts of contango and backwardation that would help you understand Contango vs backwardation.

1. Commodity Market

It is a market where HARD & SOFT commodities are traded. In this market, not the commodities are actually traded, but the price or values of the commodities are being traded.

2. Commodity

In trading, a commodity is raw material/goods which can be bought and sold. Commodities that are traded are generally of two types i.e. hard commodities and soft commodities. Hard commodities generally include a variety of natural resources like gold, rubber, oil, etc, and soft commodities are generally agricultural products like corn, wheat, coffee, sugar, etc

3. Derivative

A derivative is a hedging tool that derives its value from an underlying contractual manner.

4. Future contract

A Future contract is a customized contract between counterparties, where settlement takes place on a specific date in the future at today’s pre-agreed price.

5. Spot Price

Spot price refers to the current market price where security can be bought/ sold at a specific place and time.

6. Future price

The price of a commodity at which the counterparties agree to buy/sell the commodity in the future.

7. Premium

An amount to be paid as per contract.

What is Meant by Contango?

In certain energy and commodity markets, contango and backwardation terms are used. If we get more into deep into it, we can say that, especially in the crude oil market, these terms are used. In many books, you can see only theoretical definitions, but in practice, that concept is much different. There are two concepts of contango.

• Contango
• Normal Contango

Before starting with the theoretical definitions of contango vs backwardation, I would like to tell a small story of Mr. Bull and Mr. Bear. Mr. Bull had always dreamt of making his daughter’s wedding a big fat one! He wanted to bid adieu to her with lots of happiness and gold. But he always had this weight on his shoulders about the rising gold prices. This led to some sleepless nights. During one such night, he came up with an amazing idea. He thought, “Why not enter into a Future Gold contract”. Instantly his face cheered up with happiness and anxiety. But what was the plan that he was required to follow? The answer was, “Get into a Futures Contract”. He happened to visit one of his relatives, Mr. Bear, to give away the engagement invitations (6 months before the actual wedding). He found out that the person was bearish on gold. At that moment, he knew that he had to enter into a contract with Mr. Bear. So with one hand, he gave the invitation, and with another hand, he signed the contract. So they entered into a derivative contract. At that time, the current market price of gold was $1300 per ounce, so as per the contract, both agreed that Mr. Bull will buy gold from Mr. Bear at a price of $2600 after 6 months from today’s date. If you carefully analyze the above situation, you will note that the spot price (today) of gold was $1300, and the Future price was $2600. So a situation where the Future price is greater than the spot price, this situation of a market is called a market in Contango.

Contango Definition

Contango refers to the situation where the Future prices of stock/commodity are higher than the current spot price.

 

Let’s see the above graph in the context of contango. Remember our story of Mr. Bull and Mr. Bear. If you carefully analyze the graph carefully, you will get an idea Future price of gold (after 6 months is greater than the current market price of gold i.e. $1300. When a Future price is greater than the spot price of the underlying in the market, then this situation is called a Market in contango. This usually happens when people pay a premium for a commodity in the future instead of paying the costs of storage and carry costs of buying the commodity today.

Normal Contango

It refers to phenomena where the Future price is higher than the expected Future spot price (Expected market Price) in the market. Confused? Let’s dig deep into it. We will understand normal contango with the help of the following graph.

As you know, our story of Mr. Bull and Mr. Bear. So let’s continue with the same story. In our story, there are two counterparties i.e. Mr. Bull and Mr. Bear. They come into a Future contract to buy or sell a commodity (Gold) at a pre-agreed price and specific date. Let’s compare our story with the above context. This contract will exercise after 6 months, and today’s spot price of the contract is $1300; the Future price is $2600, yet if you analyze carefully, then you may note that the expected price of an underlying asset after 6 months is $2000. So if in the market Future price (i.e. $2600) is higher than the expected market price (i.e 2000), then this market situation is called a market in Normal Contango.

What is meant by Backwardation?

If you understand contango by heart, then you can easily predict the meaning of backwardation. Simply it is the opposite of contango. Backwardation can occur if the markets have an oversupply of commodities. Backwardation is a bearish indicator. It also indicates an immediate shortage. Generally, it has two definitions:

• Backwardation
• Normal Backwardation

Definition of Backwardation

It refers to the market situation where the Future prices are lower than the current spot prices for a particular commodity. 

Let’s understand backwardation with a simple graph. if you look at the graph carefully, you will get an idea about an underline asset, spot price, and Future price. Here,

• The underline asset is -crude oil
• Spot Price of underlying -$2700
• Future Price of underlying -$1500

Suppose there is a contract between Mr. Unhappy and Mr. Happy. In this contract, Mr. Unhappy is ready to sell his underlying after 6 months from today’s date at a pre-agreed price i.e. $1500; however current spot price of the underlying is $2700. Mr. Unhappy fears that due to some uncertain political event, the prices of crude oil are likely to go down, so he has secured future prices by entering into the derivative contract. So if there is a situation like the Future price is lower than the spot price, then this situation is said to be market in backwardation.

It refers to phenomena where the Future price is less than the expected future spot price (Expected market Price) in the market. Understand the nuts and bolts of Normal backwardation with the help of a graph.

 

Definition of Normal Backwardation

Take the same example that we have taken for backwardation. Suppose there are two counterparties; Mr. Unhappy and Mr. Happy. They have agreed to come into a Future contract to buy or sell a commodity (oil) at a pre-agreed price and date. Let’s assume the contract will exercise after 6 months and at a price of $1500. In simple words, we can say that Mr. Happy will buy Crude oil after 6 months at a price of $1500. Till now, I understand the situation more carefully than just simply looking at the graph; the expected future price of underlying after 6 months is $2000. But as per the contract, they have agreed to buy and sell a commodity at $1500. So in this situation, the Future price i.e. $1500 is less than the expected market price i.e. 2000. This market situation is called Normal backwardation.

Difference between Contango and Backwardation

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