Contango and Backwardation: Simplified

Imagine you're shopping and you see oranges for sale at $5 a pound. But you know that in a couple of weeks, oranges will be out of season and their price will rise to $10 a pound. So, you buy a bunch of oranges now and store them in your fridge. When the price changes, you can sell your oranges for a profit! 🤑

Sounds like a life hack, right? Well, this is kind of how contango arbitrage works. Except it doesn’t apply for perishable commodities. Orange you glad we told you before you started buying truckloads of fruit? 😇

Key Takeaways

• What is Contango?

  • What Causes Contango?

  • Who Benefits from Contango?

  • What is Contango Arbitrage and how does it work?

  • Advantages and Disadvantages

• What is Backwardation?

  • What Causes Backwardation?

  • Who Benefits from Backwardation?

• It Takes Two to (con)tango

• The Bottom Line

What is Contango?

In the financial world, contango happens when a commodity’s futures price is higher than the spot price, which means investors are willing to pay more for the same commodity in the future.

What Causes Contango?

Contango is usually caused by the following factors:

• Cost of carry: This refers to the expenses of storing and insuring the commodity.

• Financing Costs: The cost of borrowing money to purchase or hold an asset can also contribute to contango. If interest rates rise, the cost of financing can increase, making it more attractive for investors to buy futures contracts instead of holding the physical asset.

• Supply and Demand: In some cases, contango can be caused by imbalances in supply and demand. If there is a shortage of the underlying asset, investors may be willing to pay a premium for future contracts to secure supply.

• Speculation: If investors believe that the price of an asset will rise in the future, they may buy futures contracts as a way to bet on that increase, driving up the future price relative to the spot price.

Who Benefits from Contango?

Traders who can store assets economically and efficiently can profit from contango. Contango can also provide arbitrage opportunities for traders to make risk-free profits.

What is Contango Arbitrage and how does it work?

Contango arbitrage is a trading strategy that involves taking advantage of price differences between futures contracts and the spot price of an underlying asset to earn profits.

Advantages and Disadvantages

Contango arbitrage, like any investment strategy, comes with its own set of advantages and disadvantages. Let’s break down some of the more prominent ones:

Pros

• Risk-free Profit: When executed well, contango arbitrage can earn investors money without taking on additional risk.

• Portfolio Diversification: Contango arbitrage can provide exposure to different asset classes and market conditions, creating a more balanced portfolio.

Cons

• Transaction costs: Various overhead costs like platform fees and other charges can eat into potential profits.

• Regulatory risks: Changes in regulations can affect the viability of contango arbitrage strategies.

But we’re just getting started; now to the other side of the coin - backwardation!

What is Backwardation?

Backwardation is a market condition where the spot price of an underlying asset is higher than the futures price.

What Causes Backwardation?

Backwardation is usually caused by the following factors:

• Demand and Supply: When the current supply of a commodity is insufficient to meet demand, prices tend to rise, leading to backwardation.

• Convenience yield: In some cases, holding the physical asset provides additional benefits (e.g., production inputs, hedging against price volatility) that can justify a premium over futures prices.

• Speculation: If investors believe that the price of an asset will drop in the future, they may buy futures contracts as a way to bet on that increase, driving up the future price relative to the spot price.

It's important to note that both contango and backwardation are temporary and can reverse to the other depending on market factors. In certain markets, powerful players may manipulate prices to their advantage, to create contango or backwardation conditions.

Who Benefits from Backwardation?

Investors who accurately predict the future price movement of a commodity can benefit from backwardation by short selling near-term futures contracts or buying futures contracts that are expected to appreciate in value. Arbitrageurs can also profit from the difference in price.

It Takes Two to (Con)tango

If you’re interested in maximising your returns through interpretations of contango or backwardation markets, Multipli fi can be your best strategic move. With its user-friendly platform and helpful docs, Multipli was designed to capitalise on market conditions like contango and provide reliable yield irrespective of the direction the market moves in. It also eliminates the hassle of manual trading and complex strategies by automating the yield generation process, making it an ideal option for passive income regardless of where you are in your investing journey.

The Bottom Line

For investors seeking a potentially rewarding strategy, contango arbitrage can be a unique opportunity to capitalise on market discrepancies. As always, thorough research and an understanding of market dynamics and risk factors are essential for success.

And if you want to explore contango arbitrage firsthand, check out Multipli fi.