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Review of the difference uses of the words contango, backwardation, contango theory and theory of normal backwardation. Created by Sal Khan.
Video 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, they're normally just referring to the fact that you have an upward sloping futures curve. So technically it'd be just you would call it a normal futures curve because it's upward sloping. They would call it contango. It sounds a little fancier and if you were to hear a commodities trader say that a market is in backwardation, they're really just talking about an inverted futures curve. They're just talking about something like this. Now, if we were to be more precise with those, that's how it's used in kind of common every day lingo but if you wanted to be more precise, if someone were to tell you that we're to talk about contango theory ... contango theory may be in an academic setting, then they're talking about the notion that the future delivery price is actually higher than what people expect the price to be at that date. The problem with that is it's just a theory and there's no way to know ahead of time what that expected price actually was, so it's very theoretical. Similarly, if someone is talking about backwardation theory or even, I guess more particularly if they use the word "normal" backwardation. If they say the theory of normal backwardation, they just don't say backwardation by itself. They say the theory of normal backwardation, they're talking about the idea that the future delivery price is lower than some expected price because the seller is willing to sell it at discount so they can essentially lock their prices in, but once again it's a very theoretical idea and it's really hard to observe it in the real world because you actually don't know what the expected price is. So if someone is saying backwardation, they're usually just talking about an inverted, an inverted futures curve. If someone talks about normal backwardation or the theory of normal backwardation, they're talking about the idea that the future price, the future delivery price is below the market's expected price. I've even seen the word "normal contango" used when they're talking about contango theory. The idea that the future price would be above the expected price, so contango theory is the opposite of the theory of normal backwardation. Now, for both of the theories, you never know what this expected price is, so you can't literally observe it, a snapshot in real time and the closest thing we can do to observing either a real contango in a market or real normal backwardation in a market, is if in the example of contango, if the future delivery price right now is higher than the expected. As we get closer and closer to that delivery date, it should converge or it should move down so you can kind of observe contango over time when this price moves down as we go forward in time. This is a snapshot. This is it moving it down ... moving down as we move ahead in time. Same thing for normal backwardation. The only way that you can really observe it or even attempt to observe it, is to look at what happens to this price over time. If eight months, the deliver price is $50, but as we move future ... as we move forward in time and that contract becomes closer and closer to its actual delivery date. It will converge with the spot price and it will move up, so this observation of the futures price moving up as you get closer to delivery, that's a better way of observing that a market is experiencing normal backwardation. Hopefully that clarifies some things.