The words backwardation and contango are used in capital markets to describe a forward curve structure. When a futures contract’s forward price exceeds the spot price, a market is in contango. On the other hand, when a futures contract’s forward price is lesser than the spot price, a market is in backwardation.
In this article, we will take a detailed look at both these stock market terms and how they can help you in your trading strategy.
What is backwardation?
A market scenario in which the deferred future value of an asset, currency, or commodity is lower than the near-term or spot contract price is known as backwardation. This condition occurs in a price chart when a declining curve in future prices is observed.
When near-term demand surpasses supply, or tight supply cannot fulfil the market's current demands, backwardation occurs. The temporary disruptions in the supply chain can lead a market into backwardation, with buyers driving up prices for goods that are in short supply in the immediate future.
A convenience yield for the deliverable physical commodities could also cause backwardation. In this situation, the buyers decide to accumulate their commodities sooner rather than later. This happens because buyers expect some kind of supply gap or tight supply conditions in the coming period and want to ensure that production remains unaffected. So, they end up purchasing most of the commodities immediately instead of risking expensive costs later, which could result from supply-related issues. Consequently, the cash or spot price of the commodity surges, resulting in a higher cost at present than in the coming months, establishing a state of backwardation in the market.
Additional read: Futures and options
What is contango?
When an asset, commodity, or currency’s future prices exceed the current spot price, it is known as contango. An upward slope in future prices is a characteristic of a typical contango market.
A contango indicates that market participants predict a future increase in the asset's prices. These increases could result from a combination of predictions, including higher demand, tighter supply chains, or growing inflation, which could impact storage, financing, and insurance expenses related to a commodity’s physical inventory.
Now, let’s talk about stock index futures. Assume you were to purchase all the stocks of an index in precise quantities to match the futures contract. By paying in full initially, you would gain ownership of the stocks and the right to receive any dividends. When purchasing a futures contract, you only need to pay a portion of the contract's total value upfront, known as margin. Technically, you don’t hold the stocks listed in the index, so you are not a candidate for dividends. So, stock indices in contango infer that the current interest rate from now until the contract delivery exceeds the current dividend yield.
Additional read: Commodity futures
What causes backwardation and contango to alternate?
Based on the expectations of the buyers and sellers in the market, futures contract prices keep fluctuating across a period. A number of factors influencing price expectations are listed below.
- Seasonal supply: The availability of crop commodities is tied to the seasons, with the majority of supply becoming accessible post-harvest. Normally, they exhibit contango patterns throughout a crop year due to diminishing supplies. Yet, prices in the following crop year may be volatile, influenced by weather conditions and their effect on crop production.
- Seasonal demand: Products such as energy commodities, which experience high seasonal demand, may increase in value.
- Financing: The foreign exchange rate curve is established by the rate of interest gap between two currencies in a pair, a fact known to multinational corporations, importers, and exporters. Likewise, remember that the stock index backwardation vs. contango scenario is determined by the comparison of dividend yield and current interest rates.
- Carry costs vs convenience costs: Determinants like interest, insurance, and storage usually decide whether a manufacturer will opt for immediate delivery of a commodity. The convenience for a manufacturer of having access to more of a commodity now versus waiting for delivery will be dictated by the production flow.
Additional read: Commodity market
All the prices converge with the spot price during expiration
As the futures contract expiration date nears, the prices start to converge with the spot price, regardless of whether the market is in contango or backwardation. The futures price and spot price are the same on the final day of the futures contract.
How do backwardation and contango impact commodity funds?
You, as an investor, might prefer to steer clear from futures trading and instead only focus on commodity funds like ETFs (exchange-traded funds) and ETNs (exchange-traded notes). For fund investors, it is crucial to understand the term “roll yield”.
Commodity funds are structured to imitate the return profile of the underlying commodity, typically through the use of futures and options contracts. Fund managers tend to avoid retaining physical commodity futures in their portfolios. Therefore, they must "roll" their positions by selling the current contract and acquiring a contract with a later expiration date before the current one expires. In a contango market, assuming everything else remains constant, the manager will need to spend more on the futures contract than the amount they obtained from selling the expiring one. This negative roll yield is borne by the ETF holders, i.e., you. Essentially, the contango roll yield usually leads to fund returns that fall behind the underlying asset’s performance.
Additional read: What are options
Closing thoughts
You can learn a lot about an underlying commodity's fundamentals by determining whether a market is in backwardation or contango mode. The tricky part is to gauge the dynamics that dictate price movements. Getting the hang of these market conditions can be productive in forecasting future trends and enable you to make accurate trading calls, especially if you are dealing with futures contracts, commodity-tracking ETFs or ETNs, or even stocks (oil or gold mining corporations) sensitive to commodity price fluctuations.
