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Created by Sal Khan.
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.