What do you know about the 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 have an encounter with various market situations like contango and backwardation that may hassle your mind. Like before the war; soldier prepares himself for battle, they understand various situations of battle and act accordingly; Likewise as a trader; you must have aware about different market situations like Contango vs backwardation to make money for client and yourself.
Before swimming in the river of Contango and backwardation; let’s wear some lifesaving concepts of contango and backwardation that would help you in the understanding of Contango vs backwardation.
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.
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
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A derivative is a hedging tool which derives its value from an underlying under contractual manner.
A Future contract is a customized contract between counter-parties, where settlement takes place on a specific date in the future at today’s pre-agreed price.
Spot price refers to the current market price where security can be bought/ sold at a specific place and time.
The price of a commodity at which the counterparties agree to buy/sell the commodity in future.
An amount to be paid as per contract.
Contango and Backwardation
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-
- Normal Contango
Before starting to 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 to make 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 of such nights, 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 required to follow? The answer was “Get into a Future Contract”. He happened to visit one of his relative, 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 the 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 are agreed upon Mr. Bull will buy gold from Mr. Bear at 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 as a market is in Contango.
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 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 underlying in the market then this situation is called as Market is 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.
It refers to phenomena where Future price is higher than 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 are 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 above context. This contract will exercise after 6 months and today’s spot price of the contract is $1300, the Future price is $2600 but, yet if you analyze carefully then you may note that expected price of an underlying asset after 6 months is $2000. So if in market Future price (i.e. $2600) is higher than expected market price (i.e 2000) then this market situation is called as a market is 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 opposite to 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
- Normal 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 pre-agreed price i.e. $1500 however current spot price of 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 price by entering into the derivative contract. So if there is a situation like the Future price is lower than spot price then this situation is said to be market in backwardation.
It refers to phenomena where Future price is less than expected future spot price (Expected market Price) in the market. Understand nut and bolts of Normal backwardation with the help of graph.
Example Take the same example which 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 pre-agreed price and date. Let’s assume contract will exercise after 6 months and at a price $1500. In simple words, we can say that Mr. Happy will buy Crude oil after 6 months at price of $1500. Till now understand situation carefully than just simply look at 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, Future price i.e. $1500 is less than expected market price i.e. 2000. This market situation is called as Normal backwardation.
Difference between Contango and Backwardation
|Definition||Contango refers to the situation where the Future prices of a stock are higher than the current spot price||It refers to the market situation where the Future prices are lower than the current spot prices for a particular commodity.|
|Future Curve||Upward Sloping||Downward Sloping|
|Price Difference||Future Price > Spot Price||Future Price < Spot Price|
|Most Happen in Case of||Commodity||Oil|
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