Because the futures price must converge on the expected future spot price, contango implies futures prices are falling over time as new information brings them into line with the expected future spot price. Agricultural commodities how much can you earn from bitcoin mining such as wheat, sugar, and cotton often exhibit contango due to seasonal harvesting and storage costs. Traders must factor in warehousing, insurance, and interest rates when pricing futures contracts. In ETFs, especially those that track specific sectors or commodities, contango can cause underperformance if the fund is forced to roll over futures contracts.
Storage costs
In this article, we will explore what contango is, how it works, its implications for traders and investors, and how it contributes to price discovery in the commodity markets. It occurs when futures prices are higher than the expected future spot prices, primarily due to factors such as storage costs, interest rates, how to buy unibright and transportation expenses. While contango offers opportunities for traders, it also presents risks, particularly for investors in commodity-linked financial products like ETFs. Understanding the mechanics of contango and its effects on the market is crucial for anyone involved in commodity trading.
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For example, if it is February 1st and the VIX is at 50, and the March VIX future is at 40, the March VIX future will appreciate 10 points by its expiration date if the VIX index remains at 50. The probability of the market falling 10% is higher over a 1-year period than a 1-week period. Testimonials on this website may not be representative of the experience of other customers. No testimonial should be considered as a guarantee of future performance or success.
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That’s a negative roll yield, and that expense gets passed on to the ETF holders (you, the investor). Normal backwardation occurs when the price of a futures contract is lower than the anticipated spot price of the underlying asset at the contract’s maturity date. For Keynes, like economists after him, normal backwardation is closely tied to the roles of hedgers and speculators in the futures an easier way to buy crypto market.
When it comes to commodity investing and trading, contango is a dirty word; it has the ability to destroy value in an underlying position with the blink of an eye. US-based agency responsible for regulating the derivatives markets, which includes options, swaps, and futu… The existence of this Marketing Agreement should not be deemed as an endorsement or recommendation of Marketing Agent by tastytrade and/or any of its affiliated companies.
Currently you can choose among 6 chains, 13 money markets and more than +200 trading pairs. The ability to trade the same instrument on different markets and chains is great for diversification purposes too. By aggregating the +$20B liquidity of spot markets and tapping into the +$40B liquidity of money markets, Contango can facilitate large trades with minimal impact on both rates and price. One apparent reason is excessive demand or oversupply for spot assets or futures, causing Contango or backwardation depending on the case.
Hedgers, often industrial companies or large entities that produce or transform commodities, use futures contracts to manage price risk. The price accounts for the present spot price, the risk-free rate of return, time to maturity, storage costs, dividends, and convenience yields. It should reflect what investors believe the underlying asset will be worth on its expiry date.
- By understanding contango and how it works, market participants can make more informed decisions, whether for hedging, speculative, or planning purposes.
- When it comes to commodity investing and trading, contango is a dirty word; it has the ability to destroy value in an underlying position with the blink of an eye.
- As futures contracts near expiration, arbitrage activity increases, causing spot and futures prices to converge.
- A market is « in backwardation » when the futures price is below the spot price.
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To further reduce the risks of contango, traders and investors can diversify their portfolios across different commodities or markets. By spreading investments across various assets, traders can mitigate the impact of contango in any one market. Diversification allows investors to take advantage of market opportunities that may not be as affected by contango or could benefit from such conditions. Precious metals like silver and platinum also experience contango, particularly when inflation concerns rise. When demand for them increases due to economic instability or a devaluation of paper currencies, futures prices can rise above the current spot prices. At the very least, contango tells us that market participants—speculators or hedgers—are expecting the asset’s prices to rise over time.
This strategy can be particularly profitable when the two markets have a significant price gap. However, it requires careful timing and a good understanding of the markets. For example, silver futures markets often trade in contango—meaning prices are projected to increase the further one goes out on the time horizon. It acts as a bullish signal for traders, indicating that holding onto or entering a buy position could be a prudent decision at the current spot price. The reason behind this is that the strike price of the contract is anticipated to rise in the future.
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That means long volatility ETPs like VXX and UVXY will also appreciate over that period since they track the daily percentage changes of short-term VIX futures. During a financial crisis, such as in 2008 or 2020, the VIX index and futures spiked as the stock market collapsed violently. For example, the daily performance of VXX is equal to the daily percentage changes of front-month and back-month VIX futures. Be sure to read our guide on VXX for an in-depth understanding of this product’s mechanics. In the above curve, the March and April contracts are trading at the level of the VIX, but the longer-dated contracts are at lower and lower values the further out the settlement date.
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- Contango is a market characterized by assets being cheaper today on the spot market than at some future date using a futures contract.
- Futures are standardized agreements to buy or sell a specific asset, such as a commodity, currency, or stock, on a particular date in the future.
- You can determine if a futures market is in contango or backwardation by graphing the curve of the futures price, in comparison with the expected spot price.
- In markets where supply is abundant, traders may expect that prices will rise over time as consumption increases.
Suppose you were to buy all of the stocks in an index in the exact amounts to mirror the futures contract. You would pay all the money up front; you would own those stocks, which means you would be entitled to any dividends they pay. When you buy a futures contract, you don’t pay the full value of the contract; rather, you post a fraction of the money as margin. And you don’t technically own the stocks in the index, so you’re not entitled to any dividends paid. So, a stock index in contango would imply that the prevailing interest rate (i.e., what you would earn in interest) between now and contract delivery is higher than the current dividend yield.