Contango and backwardation are two common terms that investors and traders in commodities markets often hear. Understanding them helps gauge the price, demand and supply in the market for a particular commodity.
A trader or investor refers to a market condition for a commodity as contango when the futures price (for that commodity) is trading at a premium to spot price. This difference can arise as futures contract accounts for the spot price plus the cost of carry, storage and insurance. So often, the later-date futures contract could be more than just the underlying spot price, depending on the time until delivery.
Let us consider gold petal futures contract traded on MCX. The futures contract price of gold petal (June 2021) is around Rs 4,809 per gram which is trading at a premium to spot price of gold petal which is Rs 4,777 per gram. When you buy a futures contract, you agree to purchase gold and take delivery of the same, at a fixed price later in the future; in this case, it is in the month of June. Contango is a situation that arises when a commodity’s price is expected to rise in the future. So, in the case of gold petal contract, futures price is higher in anticipation that the spot prices in the month of June would be higher. Over time, as the futures contract nears delivery, spot and future prices of commodities get adjusted and converge. The gold petal contract for May 2021 is at Rs 4,773 which is closer to spot price.
Backwardation is the market condition where the price of futures contract of a commodity is trading lower than the spot price. Traders and investors would take a position if they expect the price of a commodity to fall in the future. So, when a contract nears delivery, the prices of the futures contract and the spot price will converge towards expiry.
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