Futures
A futures transaction is a deal in which a price is set at the present time for a contract to deliver a product at a certain date in the future. Usually, stocks are the most well-known futures instruments, but in fact the products traded through futures are very diverse: raw materials (oil, metals, agricultural products, etc.), stocks, foreign exchange, and more.
The first futures trading in the Western world dates to the 1637 Tulip bubble, when demand for tulip bulbs soared relative to supply, and contracting before harvest and forward trading was the beginning. In the Eastern world, it is considered to be the Dojima Rice Exchange near Osaka during 17th century Japan's shogunate period. The first futures exchange with the structure of today's exchanges can be said to be the Chicago Board of Trade (CBOT), founded in Chicago, USA, in 1848.
Rollover
When a contract reaches maturity, the series of actions taken to extend the contract is called a “rollover.” Rollover occurs every month in futures and futures derivatives.
Contango
Contango refers to a state in which the futures price is higher than the spot price. This situation mainly occurs due to supply and demand conditions in the spot and futures markets and the cost of carry. Supply and demand for futures contracts affects the futures price at expiration, and the reason a futures price for a specific future expiration date is priced higher than the spot price is the cost required to hold the asset, i.e., the cost of carry. Contango disappears as the futures price converges to the spot price on the contract expiration date.
The concept contrasted with contango is backwardation, which refers to a state in which the spot price is higher than the futures price. Contango provides arbitrageurs with investment opportunities: they buy commodities at the low spot price and sell them at the high futures price, realizing a profit. In addition, futures prices in contango can be interpreted as a signal of future price increases, especially during inflation, and speculative strategies using this are possible, but they are valid only if the future price of the commodity actually exceeds the futures price.
Backwardation
Backwardation refers to a state in which the spot price of an underlying asset is higher than its futures price. This state signals that the current spot price is high, and it occurs frequently, especially in the oil market. Backwardation can be understood from the relationship between spot and futures prices: the spot price is the current market price at which an asset can be bought or sold immediately, and the futures price is the price at which the asset will be bought or sold in the future.
Backwardation sends a signal to the market that the current spot price is high, and as the futures contract expiration date approaches, the spot price is expected to converge to the futures price and decline. The main cause of this phenomenon is a shortage of commodities in the spot market, which induces new suppliers to enter the market, and the resulting increase in production can cause the spot price to fall.
The advantages and disadvantages of backwardation are as follows:
- It provides arbitrage opportunities for speculators and short-term traders.
- It can be used as a leading indicator of future spot price declines.
- If backwardation persists for a long time, investors who invested in commodities may suffer losses.
- Backwardation caused by commodity shortages promotes the entry of new suppliers and can lead to intensified competition in the industry.
Topics: Derivatives
Category: Wiki/Economy