Contango is a phenomenon in the marketplace that involves a comparison between futures price and the spot price of a given security. Essentially, this means that there is an expectation that the prices associated with the front month will be lower than the prices associated with the back month. When this occurs, futures prices tend to reduce back to cited spot prices before the actual delivery date on the futures arrives.
Projecting contango requires taking several factors into consideration. One of these has to do with the carrying costs that are associated with just about any type of securities issue. Carrying costs can include such element as storage and interest. Because carrying costs are always applied to the back months, there is a built in expectation that the prices associated with a given back month will be higher than the current or front month. When this expectation proves to be true, contango exists.
While contango is a very common market phenomenon, there is an opposite market reaction that may come into play. Backwardation also can take place and have an impact on the delivery prices for futures. Essentially, with backwardation the futures end up trading at a higher rate per share as the delivery date grows near. Often, backwardation takes place when the convenience yield proves to be higher than the general risk free rate that applies.
There is no inherent reason to fear contango or backwardation. In the event of contango, the investor can more or less proceed with the original plan and delivery date with a fair expectation of realizing the projected return on the investment. When backwardation is present, the difference may not be all that significant. In the event the difference is projected to be significant, the investor can always choose to delivering as late as possible and minimize the impact somewhat. As with any investment involving futures, the investor should take steps to make realistic projections about the performance of the issues before entering into the futures contract.
