Trading Commodities Biography
Understanding contango
Investors who buy ETFs that use commodity futures contracts are sometimes surprised to see that the ETF does not move in lockstep with the price of the commodity as seen in the news, oil being a good example. This is because of a phenomenon called contango.
Contango simply means that investors are willing to pay a premium today to be sure of the price they'll get in the future, rather than waiting a month or quarter and then buying the commodity in the real-time "spot" market. For example, say oil is trading at $80 per barrel today (the spot price). Investors may be so concerned about higher prices in the future that they're willing to pay $82 per barrel now for a contract that promises to deliver oil one month from today. When the future price is above the spot price, that's contango. (The opposite situation, where the future price is below the spot price, is called backwardation.)
If the market for a particular commodity suffers from strong, persistent contango, an ETF that buys futures contracts on that commodity will perform worse than the spot price of the commodity itself. If you invest in a fund that always buys one-month oil futures contracts, for instance, and that fund has to pay $2 more than the spot price for them, the fund will essentially lose $2 per barrel each month when they roll their futures contracts. This is because they will have to sell their expiring contracts near the spot price and buy new contracts at a price higher than the spot.
Understanding contango
Investors who buy ETFs that use commodity futures contracts are sometimes surprised to see that the ETF does not move in lockstep with the price of the commodity as seen in the news, oil being a good example. This is because of a phenomenon called contango.
Contango simply means that investors are willing to pay a premium today to be sure of the price they'll get in the future, rather than waiting a month or quarter and then buying the commodity in the real-time "spot" market. For example, say oil is trading at $80 per barrel today (the spot price). Investors may be so concerned about higher prices in the future that they're willing to pay $82 per barrel now for a contract that promises to deliver oil one month from today. When the future price is above the spot price, that's contango. (The opposite situation, where the future price is below the spot price, is called backwardation.)
If the market for a particular commodity suffers from strong, persistent contango, an ETF that buys futures contracts on that commodity will perform worse than the spot price of the commodity itself. If you invest in a fund that always buys one-month oil futures contracts, for instance, and that fund has to pay $2 more than the spot price for them, the fund will essentially lose $2 per barrel each month when they roll their futures contracts. This is because they will have to sell their expiring contracts near the spot price and buy new contracts at a price higher than the spot.
Trading Commodities
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