Contango is a situation where the futures price of a commodity is higher than the spot price.
Today, in addition to transactions in the spot market for almost most investment instruments, transactions can also be made in the futures market regarding the future prices of these assets by using these as a basis. While these transactions sometimes include buying and selling opportunities against future price changes (hedging) to reduce the maturity risk in trade, sometimes they consist of speculative movements. But in both cases, price movements in the spot and futures markets vary in harmony, taking into account each other. Under normal circumstances, as the contract date approaches, forward prices and spot market prices are expected to converge.
The word contango is a concept formed by the combination of the Latin word “continuare” and the suffix “-tione” (according to some sources, it comes from the Spanish word “contengo”), expressing a disruption in continuity. It has taken its place in today’s financial world, and what the concept means is generally It is seen in assets whose prices are expected to increase. This price difference creates a profit opportunity (arbitrage) that can be obtained through buying and selling.
The supply and demand of futures contracts affect the futures price at each available expiration date. In contango, investors are willing to pay more for a commodity in the future. The premium above the current spot price for a given expiration date is generally associated with the carrying cost. In goods, the cost of transportation usually includes storage costs and, in some cases, depreciation due to deterioration, or decay.
In all futures market scenarios, futures prices will generally converge to spot prices as contracts approach expiration.
This happens due to the large number of buyers and sellers in the market, making markets inefficient and eliminating large opportunities for arbitrage. Therefore, a market in contango sees gradual decreases in price to meet the spot price as it expires.
In general, futures markets involve a significant amount of speculation.
The further contracts are from expiring, the more speculative they are. There are several reasons why an investor might lock in a higher futures price. As mentioned, carrying cost is a common reason for purchasing commodity futures.
Some producers may believe that the spot price will rise rather than fall over time. Therefore, they may hedge at a slightly higher price in the future.
Advanced traders can use arbitrage and other strategies to profit from contango.
One way to take advantage of contango is through arbitrage strategies. For example, an arbitrageur may buy a commodity at the spot price and then immediately sell it at a higher futures price. This type of arbitrage increases as futures contracts are about to expire. As expiration approaches due to arbitrage, the spot and futures prices actually converge and the contango decreases.
There is another approach to profit from contango.
Futures above the spot price can be a sign of higher prices in the future, especially when inflation is high. Speculators may buy more of the commodity experiencing contango in order to profit from higher expected prices in the future. They can make even more money by buying futures contracts. However, this strategy only works if actual future prices exceed futures prices.
Contango tends to cause losses for investors in commodity ETFs that use futures contracts, but these losses can be avoided by purchasing ETFs that hold actual commodities.
The major drawback of contango comes from automated forward contracts, a common strategy for commodity ETFs. Investors who buy commodity contracts when markets are in perpetuity tend to lose some money when the futures contracts expire higher than the spot price.
Fortunately, the disadvantages of contango are limited to commodity ETFs that use futures contracts, such as oil ETFs. Gold ETFs and other ETFs that hold actual commodities for investors are not affected by contango.
Trying to profit from contango involves taking risks that are not suitable for most individual investors.
Although risks can be predicted from the beginning, it should not be forgotten that the next movements of the markets are unpredictable.