Finance and Trading Terms Explained: What Is Contango?

By Josh Wolonick  MAR 28, 2014 1:30 PM

Our new column examines trading and finance terms that even many Wall Street veterans may not understand.

 


Even professional traders and investors can't always speak the language of colleagues working in a different segment of the financial world. With that in mind, we're launching a new weekly column looking at one esoteric or potentially misunderstood finance or trading term every week. We're kicking off with the weirdly wonderful word "contango," a term most often used by commodities traders. It's not an easy one to explain.

What is the etymology of the word "contango"?

Our term of the week originated in the mid 1800s in England and is believed to be a corruption of either the word "continuation," "continue," or "contingent." On the London Stock Exchange, when a buyer wished to defer the settlement of a trade he had made, the buyer would pay a fee, known as a contango, to the seller. The amount of the charge was determined by interest forgone by the seller not being paid. This process of paying a contango fee was common on the LSE until about 1930. Today, the word has a new, specific meaning for traders.

What exactly is contango?

When I spoke with Axel Merk, President and CIO of Merk Investments, he referred me to the definition on Wikipedia, which came directly from Investopedia: Contango is "a situation where the futures price of a commodity is above the expected future spot price." 

Now that we have the definition, what does it actually mean?

Let's begin with key elements. A futures contract, is "a financial contract obligating the buyer to purchase an asset (or the seller to sell an asset) . . . at a predetermined future date and price." So, when an investor buys a futures contract for a commodity, he or she is agreeing to pay a set price for an asset at a set point in time in the future. Likewise, a spot price is just what it sounds like: "the current price of a security at which it can be bought/ sold at a particular place and time."

So, if contango is "a situation where the futures price of a commodity is above the expected future spot price," it means that investors are willing to pay more now for a commodity to be delivered at a certain point in the future than the commodity's expected price at that future time. 

Meanwhile, the price of any futures contract in contango will theoretically decrease until it reaches the future spot price (more on this in a moment).

Why does contango happen?

Reuben Advani, author of The Wall Street MBA, explained the circumstances that would lead to a contango:

This [contango] can occur due to the costs associated with holding the commodity, such as insurance, interest, or storage. In other words, if you purchased the commodity today, you would incur these costs while holding the commodity. Contango might also occur if traders believe that future demand will exceed supply meaning that prices could trend higher.

This means that a commodity in contango is a result not of the commodity itself, but of all the resources that must go into handling that commodity. For this reason, contango generally affects non-perishable commodities that must be insured and stored, like gold, natural gas, and oil.

How can an investor take advantage of a market in contango?

As David Bakke of Money Crashers told me, "Investors can take advantage of contango by paying a bit more now for a commodity future rather than actually buying it now and having to pay carry, transport, and storage costs." In this situation, investors would expect these avoided costs to be more expensive than the premium they pay for the commodity future.

Reuben Advani described another way for an investor to benefit: "During contango, an investor can house the asset, sell it forward, and charge rent to the buyer in order to generate a profit." So in this case, the investor buys the asset outright, sells the more expensive future contracts for it, and charges rent on top of that contract.

And in general, commodity speculators will short sell an asset if it is in contango, and buy long if it is in normal backwardation (which we'll touch on in a moment).

Here is an example of how contango can work for traders:

The situation: Let's say that the market for natural gas is in contango. In this scenario, we'll say it's March 1 and the spot price of natual gas is $5.00 per 1 million BTUs (British thermal unit, a traditional unit for measuring energy), and the futures contract for November 1 delivery is $6.50 per million BTUs. Additionally, let's say the cost of storing natural gas from March 1 to November 1 is equal to $0.50 for every million BTUs.

Step 1. To profit from the contango situation, you would buy the underlying asset at $5.00 per million BTUs, and short sell the futures contracts at $6.50 each.

Step 2. You would then store the NG until November 1, at the cost of $0.50 per million BTUs.

Step 3. On November 1, the fee for your 1,000 contracts is delivered. You have locked in a profit of $1.00 per contract on the sale of your natural gas, so your profit is $1,000. That's taking into account the $500 spent on storage.

So what happens next?

With you and your fellow traders short selling all of these futures contracts at $6.50, the supply of contracts being sold has increased, which causes the price of futures contracts to drop over time (because the higher the supply, the lower the prices).

Meanwhile, as more traders buy natural gas, demand rises, and so does the spot price (though it generally increases at a slower rate than the futures prices decrease, as you can see on the chart below).

In this way, the decreasing price of futures contracts and the increasing spot price will eventually bring the natural gas market into convergence at $5.50, the expected future spot price. Upon convergence, the market for NG is no longer in contango and traders can no longer take advantage of the price difference.

The chart below illustrates this effect, and inversely, how normal backwardation works.


Source: Wikipedia

The top line represents a downward-sloping futures curve due to contango. The bottom line represents an upward sloping futures curve due to the exact opposite effect of contango, backwardation, wherein the price of futures contracts trade below the expected future spot price of an asset (we'll have more on backwardation another time).

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No positions in stocks mentioned.