Contango Definition, Examples How Does It Work?

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Contango in the VIX market drives the performance of volatility products and trading strategies, so understanding it will help you make more informed trades. The futures price in contango includes storage, insurance, and interest costs, offering a more complete picture of long-term commodity pricing. Contango affects traders and investors in different ways depending on their strategy and holding period. Below are the key advantages and disadvantages of operating in a contango market. Trading in a contango market is riskier when seeking profits because trades occur at a premium. That’s because there’s always a risk that the market will drop significantly below the agreed-upon price.

How to Recognize a Short Squeeze

Contango is a situation where the futures prices of a commodity are trading at a higher rate than the spot price. In other words, the price of the security at a future date is greater than its current price. Traders and investors generally don’t want to stomach these costs, either. Many of them have no plans to take possession of the underlying commodities.

This happens as higher futures prices reduce the capital available for future purchases, which impacts the fund’s performance. Thanks to numerous buyers and sellers, the market becomes efficient and leads to reduced large arbitrage opportunities. Thus, in a contango market, prices gradually decrease to match the spot price by expiration. For example, if the current price of wheat is 200 USD per ton, but a futures contract due in six months is trading at 190 USD, the market is in backwardation. The prices for a futures contract across different months rise or fall depending on the expectations of buyers and sellers. In this situation, the market could be oversupplied, which is why spot prices are significantly lower than futures prices.

  • When backwardation is present, VIX futures and long volatility products like VXX and UVXY all gain value over time if the VIX does not fall drastically.
  • As a practical matter, most physically settled futures contracts are offset in the market before going to the delivery stage.
  • A market that is currently in contango will experience gradual reductions in the futures price to meet the expected spot price at the delivery date of the contract.
  • At the very least, contango tells us that market participants—speculators or hedgers—are expecting the asset’s prices to rise over time.

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Contango refers to a market condition in which the price of a futures contract is higher than the expected future spot price of the underlying commodity. In other words, traders are willing to pay a premium to hold a futures contract that will be delivered at a later date. This typically happens when there are storage costs, insurance costs, and the cost of capital factored into the price of the future commodity.

Profiting from Backwardation:

That means long volatility ETPs like VXX and UVXY will also how to buy vertcoin 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.

What is Contango?

There’s no guaranteed method of profiting from a contango market, just as there’s no guaranteed method of profiting from a market in backwardation. Price fluctuations can occur swiftly in backwardation, potentially leading to increased risk and significant capital losses. Investors and traders should therefore be prepared for heightened volatility in all you need to know about bitcoin whales backwardation, and have appropriate risk management controls in place.

Contango is normal for a nonperishable commodity that has a cost of carry. It also leads to negative rolling returns as futures prices are always higher than the spot prices resulting in rolling costs for each monthly rollover. A market is “in backwardation” when the futures price is below the spot price. When the spot price is lower than that in the future, investors expect the asset to be worth more as time passes, which is what we see in most markets. This also indicates confidence in economic growth and favorable future supply-demand dynamics, the main driver of commodity prices. Most futures-contract traders will see one of these two phenomena developing before establishing their next position and they will not present a major issue.

Contango and Global Markets

As a practical matter, most physically settled futures contracts are offset in the market before going to the delivery stage. If you’re a producer or consumer of the underlying asset (crude oil or corn), you might use contango to lock in future prices by buying or selling futures contracts. The key differences between contango and backwardation lie in how they reflect market expectations and trading conditions. As a futures contract approaches expiration, spot and futures prices tend to move closer together, eventually meeting at the contract’s expiry. The table below highlights the main contrasts between the two pricing structures.

Risk Warning

Investor sentiment, speculative trading activities, and macroeconomic trends all contribute to the pricing dynamics observed in futures markets, further underscoring the multifaceted nature bitcoin for beginners 2020 of contango. While hedging with futures helps manage risk, it also means that companies need to carefully consider the costs of entering into such contracts. The cost of contango can make hedging strategies more expensive, especially for companies with long-term contracts or those heavily reliant on commodities like oil, gas, and metals. For example, as shown in figure 2, as of January 2024, the nearest-term WTI crude oil futures was trading for about $71 per barrel, versus $67.44 per barrel for the June 2025 contract.

For example, if a supply shortage emerges or if dollar interest rates drop below the gold lease rates, it would drive demand for immediate purchases. Traders with access to cheap storage facilities and insurance could benefit from contango. Understanding these concepts is crucial for anyone involved in futures markets since they can dramatically affect returns and risk management strategies across a wide range of assets. They are also important beyond derivatives trading for what they tell us about the state of the market or economy. The easiest way to avoid contango is to simply be aware of it in the first place.

What does contango tell us about the market?

This reflects strong near-term demand, the influence of convenience yield, and expectations of lower prices once the short-term pressure eases. The difference between the futures price and the expected future spot price may also include a risk premium, further contributing to the backwardation structure. Contango is a market condition where futures prices are higher than current spot prices.

  • It also helps to be aware of the underlying mechanics behind how these ETFs mirror the performance of the index or commodity.
  • The reason Contango is a problem is because if you are long on the futures, you need to roll it over each month.
  • Historically, the crude oil market has frequently exhibited contango conditions, especially during periods of oversupply or declining demand.
  • For example, in the world of stock indices, futures contracts can trade at higher prices than the index’s spot price, especially during market optimism.
  • The majority of this guide covers contango because it is present in the VIX market a high percentage of the time.

Volatility traders pay close attention to the “VIX futures curve” or “VIX term structure” because it can inform them of how volatility products will perform over time if volatility remains unchanged. It also tells us how much we need the VIX index to change for our volatility trades to work out. In a contango market, rolling into a more expensive futures contract means buying high and selling low repeatedly, which erodes returns over time. In contango, these rollovers happen at higher prices, which can cause the fund to underperform the actual spot price of the asset. However, commodity and volatility funds buy short-term futures, and contango can erode the value of these funds.

These APY values can be positive or negative, offering traders a chance to collect them via arbitrage. However, traders should be cautious with long volatility trading strategies when market volatility is already elevated, especially if it is extremely high (VIX over 50). When backwardation is present, VIX futures and long volatility products like VXX and UVXY all gain value over time if the VIX does not fall drastically. If S&P 500 volatility increases, traders will bid up SPX option prices (which are used to calculated the VIX) as the expected movements of the S&P 500 index increase. As a result, buying long-term VIX futures provides traders with a long duration of protection, justifying a higher price compared to buying a short-term future that provides only a small window of protection.