Contango and backwardation review | Finance & Capital Markets | Khan Academy

TL;DR

Contango refers to an upward-sloping futures curve, while backwardation refers to an inverted futures curve. Contango theory suggests that the future delivery price is higher than expected, while backwardation theory suggests that it is lower.

Transcript

Voiceover: Let's do a quick review of contango and backwardation because they really are opposites of each other, but they're used in different context, sometimes with the exact right meaning, sometimes with the not so right meaning, so let's clarify what we're talking about. So if you hear a commodities trader say that a market is in contango, the... Read More

Key Insights

• 🍉 Contango and backwardation are terms used to describe the shape of futures curves in commodity markets.
• 😘 Contango theory suggests a higher future delivery price than expected, while backwardation theory suggests a lower price.
• ⌛ Theories of contango and backwardation are based on the notion of expected prices, which are difficult to observe in real-time.
• ⌛ The observations of futures prices over time can provide insights into whether a market is experiencing contango or normal backwardation.
• ❓ Contango and backwardation are opposite concepts in commodity markets, representing different expectations for future prices.
• ⌛ Real-time observation of contango and backwardation is challenging due to the unobservable nature of expected prices.
• ❓ Contango and normal backwardation theories are more theoretical in nature and depend on unknown expected prices.

Questions & Answers

Q: What does contango mean in commodity trading?

Contango refers to an upward-sloping futures curve and is used to describe a market where the future delivery price is higher than the expected price at that date.

Q: What is the theory of normal backwardation?

The theory of normal backwardation suggests that the future delivery price is lower than the market's expected price. It implies that sellers are willing to sell at a discount to lock in prices.

Q: Can contango and backwardation be observed in real-time?

No, the expected prices in contango and backwardation theories cannot be observed or known ahead of time. The closest observation is the convergence of future delivery prices to spot prices over time.

Q: How can normal backwardation be observed in the market?

Observing normal backwardation involves tracking the movement of futures prices as the delivery date approaches. If the price moves up and converges with the spot price, it indicates normal backwardation.

Summary & Key Takeaways

• Contango is used to describe an upward-sloping futures curve, while backwardation refers to an inverted futures curve.

• Contango theory suggests that the future delivery price is higher than expected, while backwardation theory suggests that it is lower.

• Theories of contango and backwardation are based on the idea of expected prices, but these prices cannot be observed or known in advance.