The language of futures trading: Contango vs Backwardation

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The language of futures trading:  Contango vs Backwardation

The language used in trading futures can sometimes be daunting.  We learn this jargon first at university, then we come across media commentary with similar words that may mean nothing and for most people it may sound like double Dutch.

So what on earth is contando and backwardation?  A market is said to be in contando when the forward price of a futures contract is above the expected future spot price. Normal backwardation, which is essentially the opposite of contando, occurs when the forward price of a futures contract is below the expected future spot price. Because contango and backwardation are known states in the market, traders can employ strategies that attempt to exploit them.

A futures contract is a contract between two parties to buy or sell a specified commodity or an asset with a defined quantity and an agreed price today for delivery sometimes in the future. As it is pertained to a speculated price movement in the future, the futures forward contract price is higher than the spot, (that is generally speaking) we expect the price to be higher later on. The opposite is also true. On expiry date the price should be the same.

A contango is normal for commodities that have a cost of carry. The cost of carry is the cost of storing a physical commodity, such as grain or metals, over a period of time. The cost of carry includes insurance, storage and interest on the invested funds. If long, the cost of carry is the cost of interest paid on a margin account. Conversely, if short, the cost of carry is the cost of paying dividends. Storage costs should be added to the cost of carry for physical commodities such as corn, wheat, or gold. The futures or forward curve is typically upward sloping as contracts for further dates typically trade at higher prices.

In the index arbitrage world, we want to know how the futures are trading versus their “fair value.” The fair value of the futures and the cash index (underlying stock basket) is the difference in cash flows between holding one or the other. The inputs are the “carry effect,” derived from interest rates, the index level, and time to maturity, and the “dividend effect,” derived from the dividends that the companies in the index will pay between now and the expiration date on the futures.

When you buy ASX 200 futures, you do not actually have to pay for the full notional value of the future. You post margin. Since you do not actually own the underlying stocks, you do not receive the dividends on them. On the other hand, you earn “carry,” because you can invest the money that you would have otherwise spent buying all the underlying stocks. We can write a very simple equation to tell us what the equality would be if everything were trading at “fair value” and there was no arbitrage opportunity:

– Futures + Carry =– Index + Dividends or                                                                                                                                                                                Carry – Dividends = Futures – Index, where Futures – Index is “Fair Value”.   

Buying futures (it is a negative cash flow – we are spending money) and receiving interest on the money you do not have to spend buying the index itself is equal to buying the index itself and receiving dividends.

When “carry” is higher than “dividend yield”, the market is in contango. In this case, you would rather own the futures than the entire basket of underlying stocks, because you can earn more money on the money that you do not have to spend buying the cash index than you can receive in dividends. If “carry” is lower than “dividend yield” the market is in backwardation.  The futures are “less desirable” than the cash index because you will earn dividends by holding the underlying stocks, but you do not have any opportunity cost that you are saving by buying the futures – because the alternative reinvestment rate on that cash is low. Thus, if you go out further on the futures curve, the basis becomes even more negative – because even more dividends are paid.

http://www.investopedia.com/articles/07/contango_backwardation.asp

In my next editorial I will explain what arbitrage is about.

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