While not mentioned often, the futures market plays a very important role in investing. It’s a critical market that all investors should be aware of, as it plays a big role in the world of bonds, equities, currencies, and commodities. It can also be used as a potent tool for gauging market expectations of the future. And the futures market has special states not found in equity markets. A futures market can be in a state of contango or backwardation. This article helps you know what to do in a state of contango vs backwardation.
Futures are derivatives. This means they are a financial product that depends on an underlying asset for its price movement. Futures contracts can be bought and sold. They act as an agreement for the buyer to buy and the seller to sell the underlying asset at a specific price on a specific date.
All futures use standardized amounts of the underlying asset. This makes the market very liquid as a new contact doesn’t have to be “written” with each trade.
A futures contract buyer agrees to receive the underlying asset at a future date at the traded price. That’s why futures contracts are also divided by months. Each month has its own futures contracts, similar to options trading.
In this way, futures give speculators a leveraged option to bet on the direction of the price of an asset. Some investors use futures to hedge their portfolio’s position.
Why Are Futures Used?
Today, the majority of trade in the futures markets is focused on financial futures. This refers to futures contracts for indexes such as the S&P 500 or the Nasdaq.
However, the original use for futures was actually for the commodities market. Even today, commodity-based ETFs generally buy futures for their funds.
The original futures contracts were created for farmers
Due to the delay between planting and harvesting, farmers constantly worked in a state of uncertainty regarding the price for their goods. Oversupply in a given season could lead to an entire harvest becoming a loss-making endeavor.
With futures, these producers could sell contracts on the market so as to lock in a price for a set amount of their harvest. The stability that the futures contract provided allowed producers to make better decisions when it came to their harvests. And this made the global commodity markets more flexible and stable.
But who buys the contracts? That introduces the second major player in the futures space, the speculator. These are traders who are in the market to make profit. They give the market its liquidity. This happens because a contract may be traded multiple times between different speculators until its expiration.
The person holding the contract at the end of expiration is meant to take the underlying asset. For financial futures, this can be received in cash value. For some commodities, however, they need to receive the actual commodity shipment.
In these cases, those who hold the contract to the expiration date are generally those who want to lock in a specific price for the commodity. This can be a refiner (for oil commodities) or a multinational food company (for grain commodities), for example.
Margin: A Speculator’s Dream
As part of the standardization of all futures and in order to make the markets as liquid as possible, buyers don’t need to put up the entire value of the underlying asset. Instead, they need to pay only a fraction, which is called the margin. They pay the full amount only when the contract expires and they take possession of the asset.
Because you need to invest only a fraction of the underlying asset, futures have sizable built-in leverage. This makes them attractive options for traders because they can trade sizable amounts with relatively small accounts of cash. Some investors use them as a way to hedge specific exposure in their portfolios. For example, selling Nasdaq futures to cover overexposure to tech stocks.
As mentioned before, contracts expire on different dates and the same contract may trade at wildly different prices before then. This has important implications and leads to the contango and backwardation situation that we’re here to talk about.
What Is a Contango Market?
A contango market is a more common state to be found in futures. It occurs when the price of the futures contract is higher than the current price of the commodity. And the farther out the expiration date of the contract, the higher the price.
There are associated storage costs that pile up the longer a commodity is held, or carry costs that add up over the months for financial futures. This additional cost is usually reflected in the price of future expirations. So futures generally trade higher than current market prices.
If you look at a graph of all futures contracts by expiration date, it would be represented by an upward sloping curve from present-day to future expiration dates.
Arbitrage: the nearly simultaneous purchase and sale of the same asset in different markets in order to profit from price discrepancies.
As the underlying spot price approaches each expiration, the futures contract price will normally converge on the underlying price. This is due to the market participants arbitraging the two prices as both approach the expiration date. However, some premiums may still exist.
Premiums Affect Futures Contracts
This premium affects products such as commodity ETFs that mimic the commodity they track by buying futures. Long-term investors in some of these ETFs lose a percentage each time the ETF rolls its contracts.
Contract rolling is when a holder of a futures contract has a contract about to expire and simultaneously sells it and buys the next available expiration.
The issue here is that in a contango market there is usually a small premium to contracts. That means that multiple times a year, instead of selling and then buying at the same price (for no loss), the ETF incurs a small loss with the new purchase. This small loss is passed to the investor.
It’s important to note that ETFs that store the physical commodity that they track do not suffer from this problem as they aren’t dealing with futures contracts.
What Does Contango Imply About the Market?
While contango is normal and expected in futures markets, investors can learn what the market is thinking based on the slope of the contango curve. If a future expiration date price is significantly higher than present-day pricing, the market may be pricing in a future supply issue in the commodity or increased inflation expectations.
The slope flattens significantly when there’s a lot of demand for the asset today or when there are not enough buyers and sellers to maintain the higher price.
One rare occurrence, called super contango, occurs when the supply of an underlying commodity is greater than all available storage space for it. This causes future expiration-date contract prices to skyrocket far above current prices.
The most recent example of this was following the March 2020 stock market crash. Demand for oil dropped sharply while at the same time Saudi Arabia decided to increase its production unexpectedly.
This resulted in a significant buildup of oil inventories, to the point that oil tanker ships had to be rented out as floating storage at much higher prices than regular storage. This persisted until OPEC countries agreed to cut production and the excess supply was slowly used up.
What Is a Backwardation Market?
Backwardation is the rarer of the two market types found in futures contracts. It occurs when the current price of the underlying asset is higher than the price of the futures contract. If you were to look at a graph of the different expirations, you would see a declining slope from present-day prices.
Backwardation is less common than contango due to the storage or carry costs mentioned previously.
However, due to sudden supply or demand shocks, the status quo can be disrupted. If there is a surge in demand for the underlying asset today, buying could push its price much higher than the cost of the futures contract.
This applies to both the present market price of the asset and the futures contract with the nearest expiration date.
Example of Backwardation
Let’s say a large and powerful country suddenly declares war on one of its neighbors. Uncertainty drives many market participants to buy gold today in order to hedge against risk.
All the buying pushes today’s price of gold up above the price of a futures contract of gold that expires in a few months. In this case, a large imbalance in supply and demand causes the entire futures curve to shift direction from sloping up to sloping down.
What Backwardation Implies About the Market
When a market enters backwardation you can be sure that there is a short-term external factor causing it. If the market believed it to be a long-term or permanent factor, the entire futures curve would move upward.
The market already prices in the fact that the underlying price will drop in the future, as shown by cheaper future expiration contracts. This gives investors an idea as to whether the market believes that whatever trend is occurring is short-term or long-term.
How Investors Can Make Use of Each Type of Market
Backwardation and contango say a lot about market expectations for the future. An astute investor can look at the different expiration dates to get a sense for what the market is pricing into the short, medium, and longer terms.
- If there is a significant spike in present-day prices of a commodity and an investor believes it’s the beginning of a long-term trend, looking at the futures curve could help them decide if this is true or not.
- If the market is in clear backwardation, that could cause the investor to do more research, as the market is expecting the price of the commodity to fall in the future.
- Another way that many traders and speculators make use of these market conditions is through arbitrage between the underlying asset and the futures market, specifically, if there is backwardation or a much steeper contango curve (or even super contango).
- Traders know that backwardation is generally a short-term phenomenon. They know that the underlying asset’s price will have to drop or the future expiration date contract will have to rise. So, to profit from this short-term discrepancy, they would short sell the underlying asset and buy up the futures contract, profiting as the two converge in price.
- In the case of super contango, the investor does the opposite. He buys up the underlying asset and sells short the futures contract.
Further Reading: 14 Best Investment Apps
Should Regular Investors Pay Attention to Futures Markets?
As the name suggests, the futures markets are all about pricing in future events. For this reason, it can be a useful research tool to see what the market is thinking will happen months from now.
Is it critical? No, the futures market won’t replace proper analysis and due diligence. But it gives a good indication for market sentiment and more importantly, views about how strong an underlying trend is.