What is Contango, How it Works, Backwardation Differences

That’s a negative roll yield, and that expense gets passed on to the ETF holders (you, the investor). Contango can significantly affect Exchange-Traded Funds (ETFs) and Exchange-Traded Notes (ETNs) that track futures-based indices. These funds typically roll their futures contracts forward each month to avoid taking delivery of the underlying asset. In a contango situation, the new contract is more expensive than the expiring one, a process known as “roll yield,” which can erode returns over time.

What causes a Backwardation market?

By the time August how to buy btcc stock rolls around, the futures price may fall or the spot price may rise (or both) to meet at the same price point when the contract expires. The prices for a futures contract across different months rise or fall depending on the expectations of buyers and sellers. Storage costs is a critical factor contributing to contango in commodity markets.

If we go forward in time one month, we will be referring to an 11-month contract; in six months, it will be a six-month contract. Most commodity ETFs use rolling contracts, where they keep exchanging their existing short-term futures contracts before they expire for how to buy klima dao new ones. If prices go up, they lose money on the exchange each time, hurting their performance.

Understanding Futures Contracts

This supply/demand interplay ultimately determines the shape of the futures curve. Contango and backwardation are often found in the crude oil futures market, given that the price of this widely used commodity is highly volatile. Conversely, if they think it will fall, best crypto apps and exchanges of may 2023 as in August 2024, backwardation will result.

• And in that regard, backwardation may represent a headwind for the economy, and therefore be viewed negatively.
• Backwardation is the opposite scenario, where futures prices are lower than the expected spot price.
• Trading securities, futures products, and digital assets involve risk and may result in a loss greater than the original amount invested.
• Supply disruptions, weather events, and geopolitical events can also contribute to backwardation.

Contango and backwardation are fundamental concepts in commodity futures markets that describe the relationship between the current spot price and future prices of underlying assets. Investors should note that both contango and backwardation strategies involve risks. Also trading futures contracts requires a significant amount of knowledge, experience, and risk tolerance. A contango market is also known as a normal market or carrying-cost market. Contango is a situation in the futures market where futures prices are higher than the current spot prices of the underlying asset. It generally indicates that the market expects the asset’s price to increase over time.

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As a stock investor, maybe you want to stay away from futures trading altogether and invest in commodity funds such as exchange-traded funds (ETFs) or their cousins, exchange-traded notes (ETNs), instead. And this is how a single commodity or financial product can reflect different prices. Buyers and sellers will bid them up or offer them down, depending on what they expect the price to be by the time it reaches its delivery month. A futures contract is an agreement to buy or sell a commodity, currency, or a standardized asset (like a stock index) on a specific date in the future. However, during periods of market stress, volatility futures can shift into backwardation as market participants expect volatility to decrease over time. If the market is in contango, the new contract is more expensive than the expiring one.

How much are you saving for retirement each month?

Since contango share prices indicate the movement of the stock, traders execute strategies to benefit from these indicators. There is no particular strategy used by all traders that guarantee gains. However, the strategy below is widely used and mitigates a certain level of risk and losses. The difference is normal/inverted refers to the shape of the curve as we take a snapshot in time.

Backwardation, on the other hand, is marked by a downward sloping curve, where future prices are lower than the current spot price. In a normal market, longer-dated futures contracts are priced higher than current spot prices, due to inflation and the risk of other unknown market factors that may develop over time. The term “contango” originates from the Latin word “contingere,” meaning “to touch.” In commodities trading, contango describes a situation where futures prices “touch” or are above the expected future spot prices.

This phenomenon is often seen in commodities markets and is influenced by factors such as storage costs, interest rates, and market supply and demand dynamics. If you think the market has pushed the futures price too high because of contango, you could agree to sell a futures contract at the higher price. As an investor, consider what you think the actual spot price of a commodity/financial asset will be versus its current higher future price. Commodities prices are set by investors buying and selling contracts for the delivery of raw materials now and in the future. When prices for a given commodity are lower for delivery today than they are for delivery in the future, it’s called contango. Some commentators speculate that gold is always in contango because of its storage costs (a comparatively small ratio given its worth).

For example, if the current spot price of gold is $1,200 per ounce, but the price of gold for delivery in one year is $1,400 per ounce, the market is in contango. This situation happens due to the costs of storing and insuring the gold over the one-year period, which increase the price of the future delivery. In a contango market, this curve slopes upward, indicating higher futures prices for contracts with later expiration dates. The degree of contango can vary based on market conditions and the specific asset involved.

Because the futures price must converge on the expected future spot price, contango implies futures prices are falling over time as new information brings them into line with the expected future spot price. Backwardation occurs when the future price of a commodity is lower than its spot price. This situation is less common but can arise in markets where there is an expectation of a decrease in the price of the commodity over time. As the expiration date of the futures contract approaches, the futures price will get closer to the spot price, irrespective of the futures price being at a higher or lower level.