Futures: Contango and backwardation

CONTANGO & BACKWARDATION.

Contango and backwardation are two technical jargons used in the futures market. These terms are used to describe the position of futures price in comparison with the spot price.

In a normal market, futures price would be greater than the spot price due to the effect of cost of carry. This situation is generally referred to as a ‘Contango’ market.

In our last article, we understood that the ‘basis’ is difference between spot price and futures price at any point of time. In the case of a contango market, since futures price is more than the spot price , the basis would be a negative figure.

Backwardation is just the opposite of Contango. In some special situations, the futures prices may be decided by factors other than cost of carry. For example- When a stock market scam breaks out, it’s possible that the stock market would be driven by negative sentiments rather than fundamentals or technicals.  In such cases, futures may trade below the underlying asset’s value. Such situations, where the spot price minus futures price (basis) is a positive figure, is generally termed as ‘backwardation’ market.

CONVERGENCE OF FUTURES AND SPOT PRICES

At this juncture, one more point worth noting is that the futures price and spot price would tend to converge as the contract period draws closer. The basis would be more at the time of introducing the contract. As the maturity time approaches, the basis would gradually diminish and finally reach zero. So, the basis risk also will also fall to zero by that time.

REASON?

The reason for this can be traced back to the theory on ‘cost of carry’ and ‘arbitrage’ discussed earlier in this series.

In short, the relation between spot and futures market would be ‘backwardation’ or ‘Contango’ before expiry. As the maturity draws closer, this difference would be gradually wiped away and the prices would tend to converge. Finally, at the delivery point, the spot price and futures price would be the same.

What if the price doesn’t converge?

Such a scenario will not happen. The reason is simple. If, on the day of maturity, the futures price is more than the spot price, arbitrageurs would immediately step in and sell futures and buy spot and pocket a risk free return on the same day. If it’s the other way round, they would sell spot and buy futures and pocket the difference. This would again result in price convergence in no time.

We also tried the track the history of the term Contango & backwardation. We got some information from wikipedia and we’re reproducing that here:

The term contango originated in mid-19th century England and is believed to be a corruption of “continuation”, “continue” or “contingent”. In the past on the London Stock Exchange, Contango was a fee paid by a buyer to a seller when the buyer wished to defer settlement of the trade they had agreed. The charge was based on the interest forgone by the seller not being paid. The purpose of the buyer was to speculate in the market.

Like Contango, the term backwardation originated in mid-19th century England, originating from “backward”. In that era on the London Stock Exchange, backwardation was a fee paid by a seller wishing to defer delivering stock they had sold. This fee was paid either to the buyer, or to a third party who lent stock to the seller. The purpose of the seller was to speculate in the market.

(Source: wikipedia)

Both these deals have similarity with our own ‘badla’ system in the Bombay stock exchange. That’s contango and backwardation for you.

You may like these posts:

  1. Futures: Understanding the basic terms
  2. Types of derivatives 2 – Futures contract
  3. Futures: Principles of pricing.

6 Responses to “Futures: Contango and backwardation”

Priya Pathak

May 24, 2012 at 10:24 am

As per our knowledge, Basis= Future price – Cash price.
So the basis should be positive in contango mode. Whereas in your article it is mentioned basis is negative in contango mode. Kindly explain.

J Victor

May 25, 2012 at 7:30 pm

Hi priya pathak,

Most of the experts on this subject explains basis as the ‘difference’ between the spot price and the futures price. They don’t say which is to be deducted. I think there is no hard and fast rule on this. In majority of the reference books and websites, basis is defined as spot price minus futures price, however, i have also seen the alternative definition, as you said (future price minus spot).

If you are following F-C, basis becomes a positive figure in contango. If you follow C-F, the basis becomes a negative figure in contango.

Thanks for writing !

Priya Pathak

May 29, 2012 at 11:30 am

Thnks for Your reply.

Janardhan Swami

June 3, 2012 at 8:59 am

Well written article.

J Victor

June 3, 2012 at 7:34 pm

Hi janardhan swami .. thankyou :)

Ujas Ajmera

December 17, 2012 at 11:40 pm

Nice article…:)

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