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Contango is a market phenomenon where futures prices decline to spot prices before the actual delivery date. It is caused by holding costs and maintenance costs, and can be projected by taking several factors into account. Pullback is the opposite reaction, where futures end up trading at a higher rate per share as the delivery date approaches. There is no inherent reason to fear either phenomenon, but investors should make realistic projections before entering into futures contracts.
Contango is a market phenomenon that involves a comparison between the futures price and the spot price of a given security. Essentially, this means that there is an expectation that the prices associated with the previous month will be lower than the prices associated with the previous month. When this occurs, futures prices tend to decline to spot prices before the actual delivery date of the futures arrives.
Projecting contango requires taking several factors into account. One of these has to do with the holding costs associated with almost any type of security issue. Transportation costs may include items such as storage and interest. Because maintenance costs always apply to prior months, there is an expectation that the prices associated with a given prior month will be higher than the current or prior month. When this expectation proves to be true, there is the contango.
While the contango is a very common market phenomenon, there is an opposite market reaction that can come into play. Pullback can also take place and have an impact on futures delivery prices. Essentially, with retroactivation, futures end up trading at a higher rate per share as the delivery date approaches. Often, a retracement occurs when the convenience yield proves to be higher than the overall risk-free rate that applies.
There is no inherent reason to fear contango or backtracking. In the event of a contango, the investor can proceed more or less with the original plan and delivery date with a fair expectation of realizing the projected return on investment. When recoil is present, the difference may not be as significant. In the event that the difference is projected to be significant, the investor can always choose to deliver as late as possible and minimize the impact somewhat. As with any investment involving futures, the investor should take steps to make realistic projections about the performance of issues before entering into the futures contract.
Smart Asset.
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