What does Contango mean?
The prices of the futures contracts fluctuate because of the demand and supply of the contracts. When talking about Contango, the investors are ready to pay more in the future. The premium above the current spot price for a particular expiration date is usually associated with the cost of carry. Any fees that the investor would incur in order to hold the asset for an extended length of time can be included in the cost of carry.
Near the expiration date, all the future contract prices converge on buyers and sellers who eliminate the opportunities for arbitrage. In the Contango, the prices of such contracts start decreasing in order to reach the price of spot charts.
Futures markets, as a whole, entail a lot of speculation. Contracts are more speculative when their expiry date is further away. An investor might want to lock in a greater futures price for a few different reasons. As already stated, one typical justification for purchasing commodities futures is the cost of carrying.
How can you benefit from Contango?
Now that we have understood the meaning of Contango, let’s learn how one can bring it to use in his/her trading journey. Near the expiration, Contango brings Arbitrage opportunities. Arbitrage refers to a strategy where one makes a profit because of the difference between the prices of two markets.
As in Contango, the prices of futures contracts are higher than the spot prices. An Arbitraguer can buy the instrument in the spot market and sell the same quantity in the future market in order to book profit when the market is in Contango. Near expiration, the number of these trades increases.
Other than this, there is one more approach to making money from Contango. As discussed, the future price more than the spot price indicates a bullish momentum in the short term, especially at a time of high inflation. Speculators can buy more quantities as the prices are expected to rise in the future. This strategy works only if the spot price in the near future exceeds the future contract’s price. However, one should analyze the data according to himself/herself, take multiple confirmations, and then take the Contango into consideration and make the final call.
Example of Contango situation
An example of Contango in the stock market would be if a futures contract for a particular stock is trading at Rs. 110 per share for delivery in 3 months, while the current market price for that stock is Rs. 100 per share. This would indicate that the market expects the price of the stock to increase over the next 3 months, and the futures price reflects that expectation.
Investors can take advantage of this situation by buying the stock at the current market price of Rs. 100 per share and simultaneously selling a futures contract for delivery in 3 months at Rs. 110 per share. This would lock in a profit of Rs. 10 per share, which is the difference between the current market price and the futures price.
What is backwardation?
The market is considered to be in ‘backwardation’ when the future contract prices are less than the spot price contrary to Contango, which is also known as forwardation. Backwardation takes place in markets because of the demand and supply forces in the future market. Backwardation represents further selling pressure on the instrument. In simple words, the investors are expecting the prices to fall further below the current market price.
What is the downside of Contango?
Automatically rolling forward contracts, which is a popular tactic for commodity ETFs, is Contango’s biggest drawback. When futures contracts expire with a greater price than the spot price, investors who purchase commodity contracts during a Contango tend to lose some of their investment.
Which factors lead to Contango?
Factors like a rise in inflation in near future, anticipated future supply disruptions and the carrying cost of the instrument influence the market which results in Contango.
Now that you have understood the Contango, open Demat account with Angel One and start executing the Arbitrage strategy in order to build wealth.