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Contango - Definition
In futures trading, Contango is the phenomena where the prices of futures contracts progressively converge downwards towards a lower spot price as expiration draws nearer.
Contango - Introduction
Contango and Backwardation are two futures market phenomena which are widely misunderstood. Too many futures traders and analysts, beginners and veteran alike, take contango and backwardation to mean normal markets and inverted markets, which is totally wrong. Contango and backwardation refers to the way futures prices behave in relation to spot price over time. They are not terms describing the term structure of futures contract prices.
This tutorial shall explore in depth what Contango is in futures trading, how it occurs and how it affects your futures trading.
What Is Contango?
Contango and Backwardation refer to the way the price of futures contracts behave as expiration draws near.
The Contango and Backwardation phenomena occurs due to the fact that futures price and spot price must be the same on expiration day itself as that is the price futures traders will be trading the underlying asset at. As such, futures prices will move towards the spot price as expiration draws nearer even if the spot price remains stagnant. There are really only two ways the price of a futures contract can move when the spot price remains steady; Upwards towards a higher spot price or downwards towards a lower spot price.
When the price of a futures contract move downwards towards a lower spot price, it is known to be in a "Contango".
Basically, all futures prices that are above the spot price are subject to contango and because most inverted markets have near term futures contracts that has higher prices than the spot price, many traders have misinterpreted Contango and Inverted Market to mean the same thing.
Effects of Contango
In a Contango, due to the tendency for prices of futures contracts to move lower over time in order to converge with a lower spot price, the odds of winning is with the shorts rather than the longs. Going long in a contango market means you will make a loss when the spot price of the underlying asset goes downwards, when the spot price remains stagnant and when the spot price rises insignificantly. However, going short in a contango market means you will profit when the spot price goes down, stagnant and even when the spot price rises but insignificantly. This means that the only way one can profit being long in a contango market (holding to expiration) is when the spot price rises strongly.
What Causes Contango?
Contango can happen in both normal market or inverted market. It happens as long as the price of near term futures contract is higher than the spot price. Circumstances that lead to such higher futures price includes carrying charges on the physical asset itself.
Under such circumstances, if the spot price does not move, the price of its near term futures contract would gradually decrease until it meets the spot price on expiration day itself. The resulting loss if you have gone long on such futures contracts should reflect the carrying charges incurred should you have chosen to buy and store the physical asset yourself.