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Oil futures traderInvestors trade in commodities as a way to diversify their portfolios and take advantage of the price fluctuations of goods. Commodities are broadly categorized as one of four types – metal, energy, livestock and meat and agricultural. You can invest in commodities through futures contracts, options and exchange-traded funds (ETFs). When trading in commodity futures, you agree to buy or sell the asset at a predetermined price at a specific time in the future. Contango is the industry term for when the futures price of a commodity is higher than the current price.

Consider working with a financial advisor when preparing to invest in commodities to ensure that your moves fit your risk profile, goals and timeline.

What Is Contango?

Futures contract investing involves a great deal of speculation and risk. The further out the expiration of the contract, the greater the risk to the investor due to the potential for price fluctuations of the commodity.

In general, futures contracts represent an upward slope in the prices of goods over time. They also factor in a premium above the current (or spot) price of a commodity to account for risk and the cost of carrying the commodity. Cost of carry can include the expenses related to holding onto the commodity, such as theft, storage costs and depreciation, due to spoilage, rotting or decay.

Over time, the futures price and the spot price of a commodity converge at the expiration date of the contract as the risk and the remaining cost of carry diminishes.

Contango is a situation where the futures price of a commodity is higher than the spot price. This happens for many reasons, such as greater than expected demand, inflation and supply disruptions.

The opposite of contango is “normal backwardation.” Besides being a clumsy term, normal backwardation is the situation where the futures prices of a commodity follow a downward-sloping curve. This creates a situation where the future price of a commodity is lower than the price today. While normal backwardation is fairly rare, it is typically the result of anticipated declines in demand for a commodity, expectations of deflation or a short-term excess in supply.

What Does Contango Tell Investors?

Futures prices chartContango offers numerous clues and opportunities for investors who trade in commodities. This situation alerts traders to dislocations in the market, such as higher-than-expected inflation, supply disruptions or increased demand. Investors who act quickly can also take advantage of arbitrage opportunities when contango occurs. In this scenario, the investor would buy the commodity at the spot price, then turn around and immediately sell it at a higher futures price. This type of arbitrage occurs more frequently as futures contracts near expiration. The opportunity quickly disappears, however, because spot prices and futures prices converge as the contract expiration approaches.

When an investor is able to take possession of a commodity at today’s prices and hold that asset at a low cost, they can profit by selling it to holders of expiring futures contracts. This strategy helps to resolve contango by pushing up spot prices today through increased demand while providing greater supply in the future as contracts expire. This rebalancing of commodity supplies is known as the “carry trade.”

Another opportunity for investors to profit from contango is the inflation signals of the commodities market. Inflation often starts at basic goods and raw materials within the economy. It then flows upward into more complex and finished goods that are purchased by consumers and businesses. Understanding that inflation is taking hold can signal impacts to other areas of the market that the investor can use to their advantage. To profit from this advance knowledge, an investor may exit other positions that could be hurt by rising prices. Or they can focus investments in other areas that will benefit.

When contango occurs, investors must pay more attention to their futures contracts within their portfolios. Some contracts automatically roll forward at expiration. This can lock in losses when futures contracts expire at higher prices than the spot prices. These rolling forward contracts are typically limited to commodity ETFs, such as oil ETFs, which do not hold physical commodities. On the positive side, ETFs that hold actual commodities, such as gold ETFs, are not affected by contango.

The Bottom Line

Futures traderNo, contango is not a type of dance. Futures contracts investors expect to buy or sell commodities at a fixed price on a specific date in the future. When prices are higher, this creates contango and when they are lower, that is known as normal backwardation. These scenarios create opportunities for investors to generate a profit by taking advantage of the market dislocations. This action also simultaneously helps to bring spot prices and futures contracts back into alignment.

Tips on Investing

  • When investing in derivatives, which includes futures, it’s important to fully understand the downsides as well as the upsides. That’s where a financial advisor can offer extremely valuable advice. Finding such a professional doesn’t have to be hard. SmartAsset’s matching tool can connect you with several financial advisors in your area within minutes. If you’re ready, get started now.
  • Trusting volatile investments is a dangerous gamble. If you’re not careful, you can incur significant losses. That’s why it is always crucial to maintain a diversified portfolio. By keeping a balance between risky but profitable assets and lower-risk, lower-yield ones, you can ensure you never lose too much. In combination with a financial advisor, an asset allocation calculator can help you find the right balance for your portfolio.

Photo credit: ©iStock.com/Viktoriia Hnatiuk, ©iStock.com/Adam Smigielski, ©iStock.com/PixelsEffect

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