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Contango

Created by Sal Khan.

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  • blobby green style avatar for user kevin.marcotte
    Since it seems like the Contango theory states that the future contract price is higher than expected price, and at we can see that Contango is the falling future contract price towards spot price, wouldn't it be realistic to state that in most cases the "free" money to be made would be in shorting the far-off future contract? This shorting would then correct the future price, so does Contango exist often? Thanks.
    (9 votes)
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    • leaf green style avatar for user Ryan
      Contango is very common. In financial futures (futures that are settled in cash, where you don't physically deliver something), contango nearly always just takes into account the risk free interest rate. Meaning if you short the futures contract and invest the proceeds from the short in treasuries, how much interest could you earn? That interest is going to be the only contango that exists and will be perfectly arbitraged, so an opportunity to make free money doesn't really exist.

      Commodity futures that are settled by delivery are much harder to price because any contango will take into account storage costs and delivery costs of the actual commodity. Therefor the contango can be much larger. But you'd also have to have access to the actual physical commodity in order to take advantage of any arbitrage opportunities.

      Don't mistake "free money" for a guaranteed return. A guaranteed return can happen in most short term fixed income securities, but you still have to invest your money to begin with. Free money means arbitrage, where you can earn a risk free profit without putting up any initial funds.
      (15 votes)
  • blobby green style avatar for user pierrro
    This is a followup question to the last one (thank you, jsalvatier,for the previous answer). If the spot price on a future date is likely to be lower than the the current future price for the same date (I think I'm using the correct terminology - hope it's not too confusing) and you're worried about storage, etc., why engage in buying futures at all? Why not just wait to buy the item at that later date for the spot price?
    (7 votes)
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    • blobby green style avatar for user Sam Popplestone
      I would also like to know the answer to this question. I believe the main reason an investor would still want a futures contract rather than waiting is speculation. Despite the contango phenomenon (although it will reduce his profit margin), an investor still stands to make money on guessing that the commodity price will go up in a year. This kind of speculation cannot be done a year later because the spot price will reflect that his prediction was correct.

      (Sorry if i am wrong, i am not an economist)
      (2 votes)
  • blobby green style avatar for user Mathew952
    Even if the futures price and the spot price converge, you still have to pay the full amount you agreed to in the future because of the margin calls, right? So If the futures for Bricks were 100 dollars, but the spot price is, say, 80 bucks by the time I get the bricks, I've already transferred an additional 20 dollars in margin to the seller, right?
    (2 votes)
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    • blobby green style avatar for user Marshall Stanton
      Yes, that is the purpose of margins - to transfer money from one party to the other so that it APPEARS as though you're paying the spot price, but in reality the net effect is you're still paying the price you agreed upon. This is why the futures price is said to converge to the spot price, because you have people shifting money around behind the scenes.
      (6 votes)
  • blobby green style avatar for user Joshua Wallis
    Hi Sal, thanks for the video!

    Got a question about why the future markets are expected to be higher than the spot price. Why would someone pay more money for futures that will be "in contango" and eventually go down in price. Doesn't make much sense to me. Thanks!
    (3 votes)
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    • blobby green style avatar for user jsalvatier
      Good question. One cause is the good in question might have storage costs. Lets assume you need apples in 1 year (you're making a big pie) apples have storage costs. If you buy them now, you have to pay the current spot price and then also pay the storage costs over the year. If you buy a 1 year future contract, you avoid having to pay those storage costs, therefore you should be willing to pay a bit more than the current spot price.
      (4 votes)
  • blobby green style avatar for user ohjayjayoh
    If the expected future spot price is always thought to be less than the current price of a future for delivery at the same date, why buy these futures at all and not just wait until the date when you want it and get it forless?
    (2 votes)
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    • piceratops ultimate style avatar for user miwuc
      I think that just comes down to what good are futures contracts in general, and that's explained in previous videos. Basically they remove risk by allowing you to fix right now how much you'll pay in the future.
      If I already know I will need oil in exactly one month, I have three choices:
      1) wait for a month and buy it then
      2) buy it now and store it for a month (which has a storage cost)
      3) enter into a futures contract for delivery in a month
      Option 1 has a risk component because I don't know what the price will be in a month. Even if people think the price will be X, there's no guarantee, and I may have a hard limit on the amount I can pay.
      On the other hand, with options 2 and 3 I know exactly how much I'm going to pay, so the risk is removed, and in exchange I'm willing to pay a little more.

      PS: I know this question is years old but I was wondering the same thing and this is the conclusion I came to, and I thought it might be useful for other people.
      (4 votes)
  • starky sapling style avatar for user ForgottenUser
    Who pays for things like shipping when it comes to Futures? The buyer, seller, or broker? For instance, if someone was trading 1000 lb. of corn for $500, who pays to get the corn from the seller to the buyer?
    (1 vote)
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  • blobby green style avatar for user raj.ajgoc
    Contango and backward action can exist simultaneously for same product at different time frame.
    Ex Oil could forsee rise in price for next three months due to increase in demand and limit in supply, but could expect fall in price later due to increase in supply or fall in demand.
    Future demand, supply may be seasonal, or temperory dip or rise, so both contango and backwardation will exist for same product in different time frames of future market, c
    So the chart should be rising and falling depending on how you read the future in relation to the spot market for different future time, it can never be constant. Please why is it shown as mutually exclusive?
    (2 votes)
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  • leaf green style avatar for user chengxin199124
    At , Sal said that if the futures price didn't convert with the spot price, people will just make free money. Can you explain how this works and how is getting the free money? No matter that the futures price go up or down, the people who are selling the goods and the people who are buying the goods are still gonna get or pay the same amount of money written on the futures contract because of the margin mechanics, isn't it? So if the futures price do not convert with the spot price, how is getting the free money? Thanks.
    (1 vote)
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    • ohnoes default style avatar for user Tejas
      When a person enters into a futures contract, they are essentially agreeing to buy something on a specific date for a certain price. People, however, can make futures contracts at any time before the actual strike date.

      But, if a person could enter into a futures contract where the strike date is that same day to buy something for less than the spot price, than the buyer would be making free money, because the buyer could simply take the good, paying the agreed upon price for it, and then sell it in the spot market for more. The reverse is true as well. Margin mechanics would not help, because the futures price would not really change all that much over the one day period.
      (2 votes)
  • blobby green style avatar for user Zhooc Niu
    very clear explanation. thanks. One thing i want to ask about is on the first trading day of a new future contract, what you see is just the term structure of future prices(maybe upward sloping) and you don't know how the price of the new contract will behave when it moves towards expiry day, strictly speaking, you can't say this contract price is in contango (or backwardation) because you don't have the info. However, loosely speaking, if you know all the older contracts are in contango(because you have seen their price moves and spot price moves), there is a good chance this new contract will follow the same way. So you may also say this new contract is in contango(or backwardation) just by looking at the term structure of all contract prices. Is my understanding correct ?
    (1 vote)
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  • male robot johnny style avatar for user jon.ransegnola
    How do you know what the price of a commodity is for a future 3/4/5 months in the future? For example, if I look up crude oil, all I see is pricing for Oct 2015 contracts. Is there market pricing already for Nov & Dec contracts?
    (1 vote)
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Video transcript

Contango can be one of the more difficult to comprehend ideas when we talk about futures markets, but it's really because it's used in different contexts all the time, with slightly different meanings depending upon whether you're talking about someone participating in a futures market or whether an academic is talking about it, but first let me give you the proper definition. So the proper definition of contango, it's actually a theory and it really can't be observed. And Contango Theory says that people are willing to pay more to buy some commodity in the future than the actually expected price of that commodity so, when we talk about expected price, this is a very theoretical thing if you were to go and survey everyone participating in the futures market and say, "What price do you think silver will be in 8 months?" And if they all, you know, you took your survey, and they all told you the 100% answer, you could get this theoretical expected price and maybe that theoretical expected price is $33 so this right here is the expected price of silver in the market and you could see from this futures curve right here that delivery, the silver futures contract for delivery (expected) for delivery 8 months from now is trading above that it's trading above the expected price, and it's probably trading above the expected price because people don't want to, people who what to have silver in 8 months they don't want to buy it today and have to go rent some space and have to store the silver and have to insure the silver, and worry about someone maybe stealing the silver, they'd rather just pay for a premium in order for it, to have it be delivered in the future. So this is kind of the correct academic description of Contango Theory The theory that the futures price, on a future delivery date, is going to be higher than what the market actually expects so people to some degree are paying a premium to have the delivery of the silver, to have it delayed. Now, in practice, you will hear people say that a market is "in contango," and usually what they are talking about they're usually talking about one of two things, and they're related, but usually if they're a little bit more correct about it they're talking about the idea that the futures price. is, over time, going to converge downward to the actual spot price So what I've done here, so this is the futures curve, so this is just the price, the delivery price of the different contracts going forward in time. But this is the delivery price, the market delivery price today, right now. This is how things trend over time so in magenta, I have the spot price trending over time right over there. And then you can see that you have the 4 month the contract that's for delivery in 4 months, today it's price is a little bit under $35, but as you approach it's actual delivery date so now we're actually moving forward in time it has to converge to the spot price, otherwise people could make free money on that day. And so the delivery date 8 months out, has to converge to the spot price eventually, and so what you see is, is because the spot price hasn't moved up a lot, and you see this downward converging of the different futures price, this is what people normally refer to when they say a market is in contango, when you see the delivery price of a certain futures contract converge downward to the actual spot price so all of these are converging downward over time so it's something that you would have to observe over time not something that you would traditionally just be able to look at a futures curve but in general when you have this, you normally see that the futures delivery prices are higher the further out you go, so you have this upward sloping futures curve. So the simplest kind of analysis when people say something is "in contango," they'll just look at an upward sloping futures curve or a normal curve and then say "this is also in contango" but this isn't exactly right, it's really this movement over time.