|
Dr. Ken Rietz |
|
|
We want to look more closely at contango and backwardation. After presenting the definitions for reference, we look at how they can affect trading strategies. The working definition of contango is when the futures contract price of a commodity is greater than the current spot price. And similarly, the definition of backwardation is when the futures contract price of a commodity is less than the current spot price. (Technically, this is incorrect. The spot price that should be used is the future spot price, the spot price at the time of the expiration of the futures contract. But since that cannot be known, the current spot price us used). The price of a futures contract is negotiated, so both buyer and seller agree on a price for the commodity at a future date. As time progresses, the spot price can move, but the contracted price, of course, is fixed. As the expiration date approaches, the spot price and the current price of the contract will move toward each other; otherwise, a simple arbitrage could make money on the difference in prices. An associated item is the forward curve, which is the graph of all the prices (vertical axis) of all the different expiration dates (horizontal axis) of futures contracts on a given commodity. The spot price is, traditionally, the leftmost point of the forward curve. This makes it easy to determine if the commodity is in contango or backwardation, just by looking at the graph. Here is an example of the forward curve of NYMEX natural gas. |
 |
|
Figure 1: Forward curve of NYMEX natural gas Contrast that graph with the prices of natural gas in the recent past, given below. |
 |
|
Figure 2: Spot prices of NYMEX natural gas You can see that it is easily possible that the natural gas market could be in con- tango and/or backwardation, noting how comparatively slowly the prices of futures contracts tend to move. There is another item that is essential for trading, and that is volatility, specifically that nebulous quantity called implied volatility (IV). IV is determined by how much historic volatility affects the futures or options prices of the commodity. Generally, when the prices of the commodity are moving rapidly, the IV is high and the futures and options are more expensive, and when the prices of the commodity are calm, the IV is low and the futures and options are cheaper. This makes sense, since a wildly varying commodity price makes it harder to estimate the price of that commodity in the future. Given the potential use of futures, options, or both, there is no reasonable way to give a comprehensive list of possible methods of trading them. Besides, some people want to trade (to make money), and others will want to hedge (to protect existing commodity positions or existing crops). I will give examples that could fit either one. One last item that is important is the amount of your position that you want to cover with a hedge. For beginners, I recommend using the hedge to offset a part of potential losses, not eliminate them. Taking too large of a hedge ends up creating another position that needs to be handled, doubling the anxiety, rather than using the hedge as a safety net and reducing the stress. There are a large variety of futures and options strategies: many kinds of spreads (such as debit, credit, calendar, strip, and others), collars, strangles, straddles, varieties of butterflies and condors, and so on. I don’t have the room even to give a single example of each. Please note that these are not recommendations, just illustrations. They are also fictitious, but realistic.
|