Trading in a Futures Market

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If a commodities trader were to tell you that a commodity is in CONTANGO, they're just referring to the idea that it is cheaper today, so if you're talking about now, it's cheaper to buy that commodity on the spot market, so 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. So, in the future...in the future, it is more expensive... ...it is more expensive. So, 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. ets' say that today, you can go on the spot market and buy gold at !"#$$...at !"#$$ per...per ounce, but if you don't want the gold today, and you want to enter a futures contract to buy the gold one year from now. So, 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 !"#$$ an ounce, you could agree to buy it one year later...one year from now...for !"%$$ an ounce....!"%$$ an ounce. &nd so to a trader, this would be a market in CONTANGO. &nd what I want to point out is that this isn't that strange of a thing. 'ecause if you think about it, you have two options if you want to invest in gold. &nd gold is something you want to invest in for the long term. (ou're not going to eat gold, you're not going to use it to fuel your cars or anything like that. So, in the situation with gold, let's say you want to keep gold for definitely a year but maybe many many many years. So, you have two ways of making that investment. (ou could take your !"#$$ and buy the gold today. 'ut if you take your !"#$$ and buy the gold today, you would lose the returns on that !"#$$, on that cash, that you could invest in other places. So, you have the opportunity cost of the cash, so had you invested that cash someplace else, and you also have to store that gold. &nd in the case of gold storage, you have to find someplace really secure and maybe you need to insure the gold so people can't steal it and all the rest. So you also have the storage cost...storage cost. In general, you could save both of these costs if you enter into the futures contract. So, instead of just buying !"#$$ on the spot market today, you could enter into this contract, where you can definitely buy the gold one year later for !"%$$ an ounce and then you could take your !"#$$...you could take your !"#$$...and

get interest on it...you could get interest on it, so that will grow. &nd you'll also save money on the storage cost. So, either way, especially for commodities like gold and 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 !#$ a barrel. )nce again, I'm just making up the number. &nd the futures price is at !"#$. So, this is probably taking more into account than just the storage costs and the opportunity cost of your cash and this might be because there's a surplus...there's a surplus for oil consumption today...there's just a big glut in the market and people are just trying to dump it. )r there might be some type of perceived shortage in the future, so you can think about it either way. 'ut this is very unusual...this type of severe CONTANGO is very, very unusual...unusual. (ou would expect to see kind of minor ones...things that take this cost into consideration, but not something like this. &nd 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.

If a commodoty trader tells you that a market is in backwardation, they are essentially saying that it costs more to buy whatever commodoty they are talking about now, so now it costs more than it would to buy it later* to go into a futures contract to buy that whatever that commodity may be, silver, gold, or oil* to buy it later. So, later is cheaper. So the +uestion you might ask yourself, or any trader may ask themselves, Is this bullish or is this bearishIs this a bullish situation&nd there is no obvious rule of thumb here, but if someone says, .look, to get something now costs more than to get something later, what does that tell you about what is happening in the market-. /ell it tells you that people are desperate. So 'ecause if they were not desperate, the rational thing to do would be to wait

a little while and just get it cheaper for later or if you don't need that oil right now or if you don't need that corn right now, or if you dont need that gold right now, you could say, .look, I could enter into a futures contract for delivery of that gold or oil or corn or whatever it is at a later date for a cheaper price and I wouldn't even need to store it between now and then.. So if people were rational and weren't desperate, this wouldn't happen, but because they are willing to do this, they are willing to pay more now for a future delivery date it shows you that there might be some type of shortage. In the case of oil, maybe the oil supply hs been disrupted somehow. In the case of corn, for whatever reason some crops have been destroyed and people need to eat and all the rest. 0or commodotys that aren't used, so to speak, like gold if you see backwardation there I wouldn't say that, well it's definitely still desperation, but its not out of a core need, if gold goes into backwardation it is more because of some irrational desire to have their hands on the gold now than have their hands on the gold later. 1aybe they think society is going to collapse and the future delivery dates of gold arent actually going to hold up. /ho knows what they areSo, in general, when people talk about backwardation, because of this desperation in t the market, people tend to perceive it as a bullish signal. )bviously if people are desperate there is demand for this thing. 1y arguent is that you cannot just look at one tea leaf out of a bunch of tea leafs and say whether it is bullish or bearish, but what you could say is that there is something somewhat abnormal going on in the market due to some type of desperation. It is a little less irrational if it is due to storage, but it could be very irrational if it is due to just wanting your hands on it. 'ecause frankly, if you wanted to buy gold just for the sake of investing in gold, you aren't going to eat it or use it to fuel your car or anything like that, it would make complete sense... or even better, if you already held gold in this type of a market that is undergoing backwardation, the rational thing to do would be to sell you gold now for more money and agree to buy it back later for cheaper. &nd so when this later date comes about, you will still have your gold and you will have made some risk2free profits.

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. &nd 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, ./hat price do you think silver will be in 3 months-. &nd if they all, you know, you took your survey, and they all told you the "$$4 answer, you could get this theoretical expected price and maybe that theoretical expected price is !55 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 6expected7 for delivery 3 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 3 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. 8ow, 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. 'ut 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.

&nd then you can see that you have the 9 month the contract that's for delivery in 9 months, today it's price is a little bit under !5#, 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. &nd so the delivery date 3 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.

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