What is Contango?

Contango is a situation where the futures price of a commodity is higher than the spot price. Contango usually occurs when the asset price is expected to rise over time. Know more at IndiaInfoline.com

Sep 14, 2021 01:09 IST India Infoline News Service

Value and price balance
Contango is common usage in the futures market, especially when it comes to futures on commodities. Here we try to understand contango meaning and contango definition. To understand what is contango, you go back to the basic question of why futures generally trade at a premium to the spot. We can define contango as the spread that the futures offer over the spot plus the cost of carrying. A positive contango is a bullish indicator and a negative contango is normally referred to as backwardation

CONTANGO

In any contango, the spot price is lower than the futures price which results in an upward sloping forward curve. When you say that the specific futures trades in contango, it means that the futures contracts are trading at a premium to the spot price. Why does contango arise? There are several reasons for contango to arise and let us look at some of the key factors.
  • Firstly, there is storage cost. When you need to deliver cotton futures or copper futures after 3 months, then there is the cost of storage in terms of warehousing cost, demurrage for late offtake, etc. These will push up the futures cost above the spot. This is normally true only for future commodity futures and not for equity or currency futures.
  • Secondly, there is the insurance cost, which is a very important part of commodity futures because commodities can get damaged by theft, pilferage, forces of nature, acts of war, fire, etc. In such cases, if contracts are uninsured then it can lead to huge losses for the owner of the commodity. Hence adequate insurance is essential.
  • The third important reason for contango is the cost of carrying, which is also called the interest cost. There is a time value or time cost to futures since you are going to deliver the product only after a period of 2 or 3 months. Till that time, there is an interest cost for the margin locked in, which may be a notional cost but gets reflected in the futures price.
  • Finally, there is an important aspect of expectations or expected spot price. For example, if the stock is expected to go up over the next 2-3 months or if the commodity is likely to appreciate at price due to a supply shortage, then that would be partially reflected in the futures price by pushing up the contango.

UNDERSTANDING CONTANGO WITH EXAMPLE

Traders generally tend to get confused between futures premium and contango. These are related but they are two different things altogether. Contango is more to do with expectations of future prices. Hence this expectation of future price is considered to be positive only when the futures is more than the spot price plus the cost of carrying. We will come back to the cost of carrying later but for now, let us focus on the difference between contango and futures premium.

The futures premium is just the excess of the futures price over the spot price. For example, if the Nifty spot is trading at 17,350 and the Nifty futures one-month contract is trading at 17,500, then the futures premium is Rs.150 or if you have to express the futures premium in terms of percentage then the futures premium can be said to be 0.86%. However, this is not the contango. Let us understand contango with 3 different situations.

Scenario 1:
Take a Futures on the Nifty which is trading at a spot of 17,350 and the futures price is 17,520. Therefore, the futures premium, in this case, is 170 points for a one-month contract or 0.98%. However, when you hold the futures contract for a period of 1 month there is an interest cost for the margin of around 40% that has been paid. Let us assume that the cost of carrying, in this case, is Rs.100, which is the interest cost of holding the futures contract. That means the theoretical price of the futures should be spot price plus the cost of carrying.

That means the theoretical futures price would be 17,350 + 100 = 17,450. Therefore, in this case, the contango is the excess amount over the theoretical price. That means contango is 70 i.e. 17,420 – 17,350 in this case. The contango, in this case, shows the bullish expectations or the expected spot price for the Nifty. This contango will keep diminishing as the expiry approaches as the futures price will converge to the spot price.

Scenario 2:
Let us envisage a situation in a commodity contract wherein the spot price is Rs.8,000, the cost of storage is Rs.80, the cost of insurance is Rs.140, interest cost is Rs.110. In this case, the total cost of carrying for the commodity contract will be Rs. (8,000 + 80 + 140 + 110) = Rs.8,330. Now if the futures price is Rs.8,440, then, in this case, the contango is Rs.110 i.e. 8,440 - 8,330, which is the excess of the futures price over the theoretical futures price including the cost of carrying. Here again, there is contango due to positive expectations.

Scenario 3:
Let us look at the last situation. In this case, there is a commodity at a spot price of Rs.4,900 and the futures price is Rs.5,150. The futures are at a premium, but is the futures contract offering positive contango or an upward sloping futures expectations curve? We have data that the cost of storage is Rs.140, the cost of insurance is Rs.120 and the interest cost is Rs.90. In this case, will there be contango in the contract?

Let us look at cost of carrying first. Here, the cost of carrying is the sum of storage, insurance, and cost of funding. Therefore, the total cost of carrying is Rs.350. Therefore, the theoretical cost of the commodity futures would be Rs.5,250 i.e. Rs.4,900 plus the cost of carrying of Rs.350. Now the futures price is Rs.5,150 while the theoretical futures prices expressed as a sum of spot price and cost of carrying is Rs.5,250. That shows negative expectations of spot price embedded in the futures price and hence this shows a contract, not in contango but backwardation.

CONTANGO VS BACKWARDATION
Having looked at how contango comes about and how backwardation would broadly come about, let us understand contango versus backwardation in greater detail. One way to look at contango and backwardation is in terms of the pricing of different term contracts. When the prices are higher for longer-dated contracts as compared to shorter-dated contracts, then the market is in contango. That is because you may more for commodities or assets delivered later to cover the costs of the holder for a longer period.

Normally, costs like insurance and storage will be highest on a per unit basis for shorter periods and costs tend to average to lower levels at longer contract terms. Contango can also be looked at as the price you pay for securing your pricing for a longer period of time. However, there are also occasions when the shorter duration contracts cost more than the longer-dated ones. That’s an inverted market or backwardation and it shows the reverse of a normal contango market. The backwardation market is considered to be bearish.

Backwardation happens for different reasons. Normally, one reason for backwardation is when there is an unexpected surge in demand that suppliers cannot meet with an instant increase in output. In such cases, nearer contracts become more expensive.

FREQUENTLY ASKED QUESTIONS (FAQ)

Why is contango bad?

It is hard to say that Contango is bad because it is a normal occurrence in the futures market. However, there is a cost that contango imposes, especially if you are long on the contract. For example, contango occurs when the futures curve slopes upwards. That means; the futures price is more than the spot price. The reason Contango is a problem is that if you are long in the future, you need to roll it over each month.

Now, when you keep rolling your futures contracts in a contango market, you lose part of any price appreciation in the form of higher contango paid. Quite often, contango can offset most of your gains in price and more. However, contango is beneficial to the short roller of the contract as the contango becomes the spread that the short roller of the contract earns.

Is contango bullish or bearish?
Contango comprises several factors like the interest cost or capital opportunity cost, storage charges, demurrage charges, insurance, bullishness factor, etc. In commodity futures, all these factors are normally present, especially when you are trading futures on commodities for physical delivery. However, when you trade-in equity or index futures, the contango only consists of the interest or opportunity cost and the bullishness factor. Hence, contango by default is bullish as it shows a high element of bullishness in the asset class. It shows the expectation that spot prices will scale higher in the future.

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