Backwardation and Contango: Definition and Explanation
What does this jargon mean to us? Simply put, a contango market means that futures contracts are trading at a premium above the current spot price and backwardation means that futures contracts are trading below current spot price.
COST TO CARRY
In a normal market, futures curves demonstrate that the “cost to carry” increases over time. An inverted futures curve, sometimes called an inverted market, demonstrates that the prices for further out deliveries are dropping below the current spot price. A backwardation in market structure may be caused by shortages, geopolitical events and weather concerns. If, for example, a severe drought plagues the mid-west during the wheat growing season, then concern for the wheat crop may cause spot prices to spike. However, if the weather turns and the wheat crops are fine, later delivery prices are likely to remain stable.
A simple way to remember contango and backwardation is this: contango is when the market is dancing upward, but backwardation is when the market falls back.
The term “cost of carry” refers to the cost of owning or “carrying” an asset. Cost to carry can affect futures prices. Among commodities, the cost of carry might refer to the expenses incurred for storage and insurance. In the capital markets, the cost of carry may be the difference between the interest generated and the cost finance a position.
APMEX recommends discussing the pros and cons of investing with a financial advisor or professional.