Finance and capital markets
- Forward contract introduction
- Futures introduction
- Motivation for the futures exchange
- Futures margin mechanics
- Verifying hedge with futures margin mechanics
- Futures and forward curves
- Contango from trader perspective
- Severe contango generally bearish
- Backwardation bullish or bearish
- Futures curves II
- Contango and backwardation review
- Upper bound on forward settlement price
- Lower bound on forward settlement price
- Arbitraging futures contract
- Arbitraging futures contracts II
- Futures fair value in the pre-market
- Interpreting futures fair value in the premarket
Review of the difference uses of the words contango, backwardation, contango theory and theory of normal backwardation. Created by Sal Khan.
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- Why would a seller want to lock in a lower price if generally the expected price would tend to be closer to the spot price? And a related question is, does volatility benefit a seller more than a consumer?(9 votes)
- If you are the leader of a huge corporation you are responsible for paying thousands of people. Their wages won't go up or down depending on the market price, so the price of the commodity changing a lot can ruin your business. So if you are able to guarantee that you will sell in the future the security is worth the loss in profit.(22 votes)
- how accurate are futures prices at predicting prices? which direction is more common for converging?(1 vote)
- The point of the futures market is not to predict prices, but to allow for people buying and selling the underlying to hedge against future price volatility.
For example, look at stock and bond futures. The price 6 months from now is in no way a prediction of where the index will be in 6 months. It is merely the price of the next future to expire, adjusted for the risk free rate of return. It cannot be anything else or else someone would be able to make a risk free profit.
Things get a little more tricky with physical commodities because you have to factor in storage and delivery costs. But still, they are not a prediction of future prices, they are merely a tool for people who buy and sell commodities to lock in prices and avoid volatility.(3 votes)
- Let's use the notation E(X_t,s) for the market price at time s, where t is the time the expectation is calculated. Does the "expected price" in the video mean E(X_8,8) or E(X_0,8) ?(2 votes)
- If I am reading your notation/question correctly, the "expected price" in the video is E(X_0,8). As time goes on, the expected price tends to get closer to the spot price, so that E(X_4,8) is going to be closer to the spot price at time 4 than E(X_0,8) was at time 0. If everything is working properly, E(X_8,8) is equal to the spot price at time 8.(1 vote)
- so if downward convergence of futures prices to spot price is evidence of contango, defined by futures price > E(future prices), are we implicitly saying that the spot price representative of E(future prices)? This makes sense to me if we assume that prices move in random walk, making the spot price the best estimate of future prices.(1 vote)
- Why would futures price be decreasing in backwardation if backwardation is when the futures price is below the current spot and should increase to converge to the spot price at maturity.(1 vote)
- Can a situation occur where you have a 'contango' shaped futures curve wherby the future price is still less than the "expected" future price? Ie the futures price movement may track flat over time and then move higher?(1 vote)
- So is there always arbitrage opportunity in both contango and backwardation. In contango couldn't you just buy the security for spot price and short it in the future and vice versa for backwardation? Or does storage and delivery prices offset most arbitrage opportunity?(1 vote)
- is there any circumstance that future's price move down towards the spot price in backwadation? means the spot price keep going down?(1 vote)
- Is it fair for me to assess deep ITM Call LEAPs as being in backwardation when the market is bullish?
This week I bought some deep ITM WMT (Walmart) LEAPs for very little premium against today's prices. If the bull market continues and thus the expected price is about $10 more than today's price, then my options should converge with the higher price making capital gains while forgoing dividends. Is this an example of backwardation?(0 votes)
- The terms contango and normal backwardation are generally used in reference to commodity futures/forward markets only.
The LEAP is an option that gives you the right, but not the obligation to purchase the Walmart shares whereas in the futures market for oil, wheat etc, there is an obligation to buy or sell that commodity at that price. This "option" without obligation reflects a totally different risk level which is more associated with how much the asset moves (it's implied volatility) rather than the expected price of that asset X years from now. This is different than the futures market which is more based on the expected demand for the commodity and the opportunity cost of storing that asset (I could use that oil to run a tractor that would yield harvest rather than have the oil sit in storage -- thus there is some value in consuming the asset now rather than just purchasing it and storing it). The expected price is where demand and supply intersect for a commodity at some point in the future.
Interesting that you mention dividends as dividends play an important role in options as they reduce the value of an option. If you compare a 1 year option price to a 1 year share price of an asset with dividends, the option price will vary greatly even if the volatility is the same (you are foregoing all the dividends when you lock up your money in the premium when you could have instead bought the stock -- especially important in LEAPs as the money is stuck for a longer term).(2 votes)
Voiceover: Let's do a quick review of contango and backwardation because they really are opposites of each other, but they're used in different context, sometimes with the exact right meaning, sometimes with the not so right meaning, so let's clarify what we're talking about. So if you hear a commodities trader say that a market is in contango, they're normally just referring to the fact that you have an upward sloping futures curve. So technically it'd be just you would call it a normal futures curve because it's upward sloping. They would call it contango. It sounds a little fancier and if you were to hear a commodities trader say that a market is in backwardation, they're really just talking about an inverted futures curve. They're just talking about something like this. Now, if we were to be more precise with those, that's how it's used in kind of common every day lingo but if you wanted to be more precise, if someone were to tell you that we're to talk about contango theory ... contango theory may be in an academic setting, then they're talking about the notion that the future delivery price is actually higher than what people expect the price to be at that date. The problem with that is it's just a theory and there's no way to know ahead of time what that expected price actually was, so it's very theoretical. Similarly, if someone is talking about backwardation theory or even, I guess more particularly if they use the word "normal" backwardation. If they say the theory of normal backwardation, they just don't say backwardation by itself. They say the theory of normal backwardation, they're talking about the idea that the future delivery price is lower than some expected price because the seller is willing to sell it at discount so they can essentially lock their prices in, but once again it's a very theoretical idea and it's really hard to observe it in the real world because you actually don't know what the expected price is. So if someone is saying backwardation, they're usually just talking about an inverted, an inverted futures curve. If someone talks about normal backwardation or the theory of normal backwardation, they're talking about the idea that the future price, the future delivery price is below the market's expected price. I've even seen the word "normal contango" used when they're talking about contango theory. The idea that the future price would be above the expected price, so contango theory is the opposite of the theory of normal backwardation. Now, for both of the theories, you never know what this expected price is, so you can't literally observe it, a snapshot in real time and the closest thing we can do to observing either a real contango in a market or real normal backwardation in a market, is if in the example of contango, if the future delivery price right now is higher than the expected. As we get closer and closer to that delivery date, it should converge or it should move down so you can kind of observe contango over time when this price moves down as we go forward in time. This is a snapshot. This is it moving it down ... moving down as we move ahead in time. Same thing for normal backwardation. The only way that you can really observe it or even attempt to observe it, is to look at what happens to this price over time. If eight months, the deliver price is $50, but as we move future ... as we move forward in time and that contract becomes closer and closer to its actual delivery date. It will converge with the spot price and it will move up, so this observation of the futures price moving up as you get closer to delivery, that's a better way of observing that a market is experiencing normal backwardation. Hopefully that clarifies some things.