|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 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.
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.