Table of contents
A super contango is when the spot price of a commodity shoots up to be much higher than its futures price
Super contango is an extreme version of a normal market condition in futures trading. In this article, we’re going to explore what a super contango is, why it happens, and how.
But before that, here’s some background on what futures trading is.
Basics of futures trading
Imagine you’re a coal mining company and mine a bumper load of coal in one year. You know prices might fluctuate by the time you sell it, so you want to lock in a profitable price today. You will enter into a futures contract.
A futures contract is an agreement between a buyer and a seller to exchange a specific underlying asset at a predetermined price on a future date.
These underlying assets could be anything from commodities like gold, copper, corn, etc. to stocks, indices, anc currencies.
It’s like shaking hands on a deal today to ensure a set price later, regardless of the actual market price at that time.
Here’s a breakdown of all the major players involved:
- Buyer (long position): Agrees to buy the underlying asset at a specific price on the expiry date.
- Seller (short position): Agrees to sell the underlying asset at a specific price on the expiry date.
Important terms to remember
- Spot price: This is the starting point, reflecting the current market price of the underlying asset.
- Cost of carry: This includes storage, insurance, interest, and any other expenses involved in holding the asset until the delivery date.
- Time to maturity: The closer the expiry date, the less the cost of carry impacts the futures price.
- Market expectations: The price also reflects market sentiment about the future price of the underlying asset. If everyone expects oil prices to rise, the futures price will be higher than the spot price to account for that anticipation.
Understanding what a contango is
All these factors mentioned above are woven together in a complex formula to arrive at the final futures price. In normal market conditions, the futures prices are supposed to be slightly higher than spot prices due to the cost of carry and the time value of money. This is called contango.
Super contango takes this a step further. It occurs when the futures price is significantly higher than the spot price, indicating a much larger gap than usual.
This typically happens due to an excess supply of the commodity, leading to scarce inventory storage. When a commodity is everywhere, storage facilities can fill up, making it more expensive to hold onto the physical product. The cost of carry, hence, is much higher than normal.
This cost is reflected into the futures price because the cost of carry is an input to this final price. Futures prices, as a result, become much higher than spot prices.
Real-life example
A dramatic example of super contango happened in the oil market in April 2020. Due to the COVID-19 pandemic, demand for oil plummeted, leading to excess supply.
With storage tanks filling up, the cost of storing oil (renting tankers for example) skyrocketed. This caused super-contango, where the price of futures contracts became much higher than the spot price, even dipping into negative territory for a brief period.
Profiting from a super-contango
One simple way to profit from a super-contango is to figure out a way to store the asset for less than the market price.
If you can store the asset as inventory for lower than the market price, you can sell the same asset later at the higher price, making a risk-free profit.
All you need to do is make sure that your costs are lower than the profit spread between the spot and futures prices, and the interest payments you need to make for the borrowed capital (if applicable).
Frequently Asked Questions
There are several. Some of which include very high storage costs, financing costs, and market volatility. All of these are unpredictable to a large extent and can very rapidly eat into your profits if you’re not careful.
Absolutely not! Super contango trading involves complex calculations, managing inventory (for physical delivery) or margin requirements (for futures spreads), and navigating volatile markets. It’s best suited for experienced traders who can handle these risks.
Options can be an even more complex strategy for super contango. While spreads using options can be profitable, understanding options pricing and greeks (measures of options risk) is very important. This strategy is best left to experienced options traders who can navigate the additional risks involved.
Contango-focused ETFs can add some diversification, but they’re pretty risky. These ETFs tend to be more volatile than traditional stock or bond ETFs.
For agricultural commodities, super contango might arise after a harvest glut, when storage capacity is maxed out, leading to high storage costs. But for other commodities like gold and oil, geopolitical events like wars, sanctions, or natural disasters are more common. In fact, excessive buying by speculators anticipating those hikes can create a self-fulfilling prophecy of price appreciation, which can also create super contango.
Leave a Comment