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.