In this post, I will explain to you contango vs backwardation with simple examples and charts. Moreover, I will show how this knowledge can help you to get more profits trading futures.
So, the futures market of a particular commodity is either contango (normal) or backwardation (inverted market), on the basis of the price relationships of contracts in different delivery months.
Contango – the normal futures market
A normal futures market occurs when the price of the nearby futures contract is lower than the price of the deferred (distant) futures contract. In other words, it is a futures market in which the distant months are selling at a premium to the nearby months.
This kind of market reflects an adequate supply of the commodity. A normal market reflects a discount basis, because cash prices are lower than the futures prices.
It is also called a carrying charge (storage) market or futures price in contango, because the price difference between contracts for various deliveries reflects carrying charges. Carrying charge is the cost to hold (or store) inventory of the commodity.
In efficient markets, commodities futures contracts trade at the price that includes the cash price plus the carrying charge. Carrying charges should account for the price difference between futures contracts of differing delivery months in a normal market. When futures contract prices equal or exceed the cash price plus full carrying charges, it is known as a carrying charge market or contango market.
Also, when the cash and futures price difference exceeds carrying charges, arbitrage opportunities exist. By buying the nearby contract and simultaneously selling a distant contract the price that exceeds the carrying charges, the arbitrageur profits as prices return to their normal relationship. Arbitrage is the opportunity to profit from such temporary abnormal price differences and, when used correctly, is relatively riskless.
Arbitrage in Contango Market. Example
Assume that the carrying costs for silver (storage, interest, and insurance costs) are $.05 per month. The silver market reflects the following prices:
By buying May futures and selling July futures, the arbitrageur will profit by $.02 per ounce. The $.10 cost of storing silver for two months added to the purchase price of $7.04 totals $7.14. Because the sale price was $7.16, the profit is $.02 per ounce.
An arbitrageur exploits discrepancies (often very small) in price between cash and futures markets. Many traders consider arbitrage is risk free. However, transaction cost associated with trading could reduce or eliminate any profits.
Backwardation – the inverted futures market
In a backwardation or inverted market, the price of the cash market or the price of the nearby futures contract is higher than the price of the deferred (distant) futures contract. Because of the inverted relationship between cash and futures prices, an inverted market reflects a premium basis – in other words, cash prices are higher than futures prices.
Inverted markets occur when the supplies are not adequate, and they translate to relatively high cash market prices.
Backwardation is always caused by short supply – not increased demand!
Contango (normal futures market): Prices of distant contracts trade higher than the price of nearby futures contracts. A normal market is also known as a carrying charge market or contango market.
Backwardation or inverted futures market: Prices of distant contracts trade lower than prices of nearby futures contracts except for interest rate futures markets, which is inverted when distant contracts are at a premium to near month contracts. This is also known as a backwardation market. this may happen if there is a current shortage of a commodity.
Normal market: Carrying charges limit price differences between nearby and distant month futures prices.
An alternative way to visualize the differences between contango and backwardation appears in the graphic.
Contango vs backwardation. How to profit from this knowledge?
As you already know from this post backwardation or inverted market exists when a nearby contract has a premium. But why that happens and how you can profit from it? It is very easy. Premium means someone is ready to pay a higher price to get a commodity now. He doesn’t want to wait for the next delivery. He needs commodity now for his production now. In other words, an inverted market is driven by real producers and users, not speculators!! Thus, in most cases, we see a parabolic rise in the commodity price when there is a premium. It is one of the key factors I use to spot big trends. But it is not the only one. I explained this approach in detail in my trading course.
Wishing you a great week!
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