From the February 2013 issue of Futures Magazine • Subscribe!

How to leverage market contango and backwardation

A snapshot in time

A futures curve is a graphical representation of the current prices for the various delivery dates of a particular instrument. A trader can graph a futures curve for a specific instrument by plotting contract expiration dates along an x-axis with the corresponding futures prices along a y-axis. The current price is the spot price (the price at which the contract could be bought and sold today), and the various futures contracts’ prices are plotted going forward in time. “Hypothetical futures curve” (below) shows a hypothetical example of a normal futures curve (in yellow) and an inverted futures curve (in blue). The first price plotted represents the spot price.

A futures curve that shows prices that increase as time moves forward is called a normal curve, sometimes referred to as a normal market. This type of curve reflects that the cost to carry increases with longer expiration. In general, traders are willing to pay a premium to avoid the costs associated with transporting, storing and insuring a commodity; therefore, the furthest-out contracts typically are priced higher. A normal futures curve appears upward sloping.

An inverted curve, or inverted market, on the other hand, exists when the prices for faraway deliveries are below the current spot price. Prices for the commodity may be higher today because of a temporary shortage in the cash market brought on by a variety of factors such as weather, natural disaster, war or another geopolitical event.

For example, if a Gulf Coast hurricane disrupts oil refinery production, near-term contracts may be priced higher than those with further-out expirations. Similarly, silver might be in tight supply because investors with physical silver are holding on to it; therefore, the price of the current contract may be higher than later ones. The prices for future deliveries will fall because the supply disruption is expected to end. When these prices are plotted on a graph, the resulting curve appears downward sloping. 

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