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Contango from trader perspective

What a trader means when they say that a market is in contango. Created by Sal Khan.

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  • leaf green style avatar for user Zaphod Beeblebrox
    so does this mean that it is free to enter into a futures contract?
    (5 votes)
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  • winston baby style avatar for user ahmet
    by the way it is presented here, doesnt contango imply an immediate arbitrage opportunity ? buy spot and sell at future maturity and you pocket the difference.
    (2 votes)
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    • blobby green style avatar for user newbreedusa
      Contango does not imply automatic arbitrage possibility. Contango however, does have many variables, and professional traders actually keep most prices in line with theoretical values and expectations. That said, there may be an arbitrage because the futures price for the one year contract may be mispriced. In that case, you'd likely have to be a pro trader in order to take advantage of the short-term misalignment. Retail traders would not be able to play this arbitrage.

      For example, the one year Futures price, based on all of the variable inputs mentioned should be priced at 1600 but it temporarily moves up to 1605, one could sell it and buy the spot gold. Performing this operation requires cash, holding the bullion until the futures contract come into the delivery date in one years time. But one would then have to swap the bullion for the New York receipt which the Futures contract on Comex is based on.

      There's also a difference between the types of metal; spot metal is normally based on London bullion, which is a different purity than Comex gold. Comex gold futures that become physical gold, are deliverable or receivable in NY.

      As you can see, with location difference, purity difference, and more, there is an arbitrage that can go on, and does, but once again, but it is a big operation.
      (2 votes)
  • blobby green style avatar for user shreya.das1801
    Contango is a normal situation, considering opportunity cost of money & storage costs for commodities. What about futures, where the underlying asset is shares of a company?
    (2 votes)
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  • leaf grey style avatar for user Adrian Muljadi
    say a severe contango situation exist, like the oil example in the video.

    What stops us from buying oil at $50 at the spot price, enter into a futures contract and sell that oil at $150 for a super high return on investment at no risk?
    (1 vote)
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    • male robot hal style avatar for user Andrew M
      You have to ask why the contango would be so high. It would only be that way if the cost of storing oil were very high. That's where contango comes from: the cost of financing and storing a current purchase for sale later.
      (3 votes)
  • leaf red style avatar for user Greg
    There seems to be a Terminology mistake in this lesson. I believe Contango (and also Backwaredation) refers to the difference of the "Future" spot price of a contract, not the "Day 0" spot price of the underlying asset. e.g. it is not today's selling price of oil. It is, today's selling price of oil to be delivered (Delivery Date/Maturity Date) at a future date.
    (1 vote)
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    • ohnoes default style avatar for user Tejas
      Yes, contango means that the futures price for a given transfer date decreases as you get closer to the transfer date. In other words, futures prices for a transfer 1 year out will be greater than the spot price 1 year from now. That is the rigorous definition. However, there is a common definition in which it means that futures prices for a transfer 1 year out are greater than the current spot price. They should have the same result, assuming nothing weird is expected to happen between now and 1 year from now.
      (2 votes)
  • blobby green style avatar for user Mark Gallant
    So sal this is great. You mentioned a futures contract in contacting and buying the gold in one year at 1600. So since it is priced at 1600 in one years time are you buying an option to get it at that price or expect us can get at that price? Just because it is selling at 1600 today does not mean it will still sell at that price in a year does it?
    (1 vote)
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    • blobby green style avatar for user Philip Ratnowsky
      You are not buying an option. It is an enforceable contract. Meaning you HAVE to buy it, you cannot change your mind later regardless of what happens. The most basic way to profit off futures (which sal will surely go over in a later video) is to enter into a contract to buy gold at $1600 a year from now, and hope that before the year is over the price of gold goes up to $1700. The contract you own is now worth the $1700 and you sell it for a $100 profit
      (2 votes)
  • duskpin ultimate style avatar for user tuannb1997
    If we choose to buy a commodity that is in contango one year from now, wouldn't it then still cost us storage expenses as well ? Additionally, from the commodity suppliers' point of view, if they're certain that the good they are producing now would yield higher price in the future, would they tend to supply less of the good at the moment, which subsequently leads to an increase in price of the good RIGHT NOW (supply curve shifting up and to the left) ?
    (1 vote)
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  • blobby green style avatar for user Marco Alessandro Doppierio
    what I do not understand is: if today all or most of market players estimate agree upon an expected spot price of the commodity at the future deliivery date, while such price estimate is not reflected into the pricing of futures today for that same delivery ? (taken aside of course the contango driven by opportunity cost of cash and if any warehousing cost of the commodity) ?
    (1 vote)
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  • male robot donald style avatar for user harry park
    So when the Future's Price is converging down to Future Spot Price, the Margin Mechanism is at work right?
    It's not like as if the two parties involved in the Contract was gaining or losing money because of Contango because of the Margin Mechanism am I correct?
    So what's the point of learning Contango?
    (0 votes)
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    • piceratops seedling style avatar for user rluo
      Remember that when the margin mechanism is at work, the differences in the spot price vs the future price is adjusted through the margins, but you have not actually performed the underlying forward contract transaction.

      Therefore if the apple farmer received $10 from the pie chain due to the drop in apple futures price, the apple farmer would have profited $10, while the pie chain would have lost $10. The margin mechanism would only cancel out in effect, if the apple farmer then decides to sell the apple for $190, while the pie chain buys the apple for $190.

      But what if they were not apple farmers and the pie chain? What if they were two investors simply speculating against the prices of apple? Then you can see how the party going short (to sell) would have profited, and could simply buy the contract back at the lower price, in order to cash in on the margin mechanism profit. Even though it is a contract, not an option, rarely does physical commodity exchanges actually takes place.
      (2 votes)

Video transcript

Male voiceover: If a commodities trader would tell you that a market is in Contango, they're just referring to the idea that it is cheaper today. So if we're talking about now, it's cheaper to buy that commodity on the Spot Market. It's cheaper to buy it on the Spot Market than it is to agree to buy it at some futures date or some future date using a Futures or Forward Contract. In the future, it is more expensive. It is more expensive. Let's say that that commodity is gold and I'll just make up gold prices for the sake of simplicity. This isn't the current gold prices. Let's say that today, you can go on the Spot Market and buy gold at $1,500 per ounce but if you wanted to buy gold, if you don't want the gold today and you wanna enter a Futures Contract to buy the gold, one year from now. Let's say the future is now one year later, one year from now. Instead of buying, let me write this down. This is the Spot Market. Instead of buying in the Spot Market for $1,500 an ounce, you could agree to buy it one year later, one year from now for $1,600 an ounce and so to a trader, this would be a market in Contango. What I wanna point out is that this isn't that strange of a thing because if you think about it, you have two options. If you wanna invest in gold and gold is something that you wanna invest for the long term. You're not gonna eat the gold. You're not going to use it to fuel your cars or anything like that. In the situation with gold, let's say you wanna keep gold for definitely a year but maybe many, many, many years. You have two ways of making that investment. You could take your $1,500 and buy the gold today but if you take your $1,500 and buy the gold today, you would lose the returns on that $1,500 on that cash that you could invest other places. You have the opportunity cost of the cash. So had you invested that cash some place else? And you also have to store that gold. In the case of gold storage, you have to find some place really secure and maybe you need to insure the gold. You need it so that people can't steal it and all the rest. You also have the storage cost. In general, you could save both of these costs, if you enter into the Futures Contract. Instead of just buying $1,500 of the Spot Market today, you could enter into this contract where you can definitely buy the gold one year later for $1,600 an ounce and then you could take your $1,500, and get interest on it, so that will grow and you'll also save money on the storage cost. In either way, especially for commodities like gold, precious metals, things that aren't consumable, things that people don't need immediately for consumption, it's not unusual for a market to be in Contango. Sometimes you might see a severe Contango maybe with something that is consumable. So maybe right now, oil is trading at $50 a barrel. Once again, I'm just making up the numbers and in the future, the Futures price is at $150. This is probably taking more into account than just the storage cost and the opportunity cost of your cash and this might be because there's a surplus for all oil consumption today. There's just a big glut in the market and people are just trying to dump it or there might be some type of perceived shortage in the future. So, you could think about it either way but this is very unusual. This type of severe Contango is very, very unusual. You would expect to see kind of minor ones. Things that take cost into consideration but not something like this. In something like this, you can usually arbitrage it out and make some money assuming you can store oil or you have oil to sell or buy and all the rest of that.