Scaramouche, Scaramouche – Will You Do The Contango?

Yes, “contango” as opposed to the Bohemian Rhapsody’s “fandango”. My girlfriend treated us to tickets to the musical ‘We Will Rock You’ over the weekend to celebrate our one year anniversary and if you’ve heard of the legendary band Queen, you’ll understand the reference in the title of this blog post.

Contango is a word used in the futures market. Before I define contango, it would be best to get a basic feel for how a futures contract is priced. At the very basic level a futures price should be equal to the spot price (current price) plus an amount equal to the cost of storing, holding and insuring the underlying asset until time of delivery. So in other words, let’s say that gold is currently $900/oz. A December 2008 futures contract on gold might be priced at $920/oz. Not because it’s expected that gold will rise $20/oz, but rather the cost of storage (and insurance) for one ounce of gold from now until December 2008 would be $20/oz. In theory, for a hedger you would be no further ahead if you bought gold today for $900/oz and stored it until December at the added cost of $20/oz versus buying the futures contract and taking delivery at $920/oz in December.

Contango in it’s most oft quoted definition refers to the futures price being higher than the spot price – however to be more accurate it refers to the futures price being higher than the expected spot price. When the opposite is true (when the futures price is LESS than the spot price) this is known as backwardation. This can happen when there is a short term lack of supply or increased demand for a temporary period for the asset in question.

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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