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Old 02-26-2009, 12:08 PM   #1 (permalink)
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Contango, Backwardation, and the Futures Curve


Contango, Backwardation, and the Futures Curve

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Next Lesson - Full Futures Course

In our last lesson we began a new module on the logistics of futures trading, with a look at the 4 different components which make up the price of a futures contract. In today's lesson we are going to continue this discussion with a look at something which is known as the futures curve, and the two different types of futures curves.

As we learned about in yesterday's lesson the price of a futures contract reflects the spot price, the risk free rate of return, storage costs, and something which is known as a convenience yield. As the risk free rate of return and storage costs are both generally larger the further you go out into time, for most futures contracts price also increases the further you go out in time. As an example, this lesson was produced in February of 09, and today's prices for Cotton Futures are as follows:

March 09 Contract: $.4279
June 09 Contract: $.4360
July 09 Contract: $.4490
October 09 Contract: $.4773
December 09 Contract: $.4919

As you can see here, the price of the futures contract increases the further out in time we go, reflecting the fact that storage costs and the risk free rate of return also increase the further out in time one goes. As we can also see here, if we plot these prices in a graph it is upward sloping. An upward sloping futures curve as we have just constructed using cotton futures prices, is what is referred to as a Normal Curve, or Normal Market. As we also discussed in our last lesson, as futures contracts move closer to their settlement date, price converges to the spot price for the underlying instrument. Because, in this example, the futures prices are above the spot price, the futures will converge towards the spot price from above. This process of prices converging towards the cash market from above is known as Contango, which is why you will often here normal markets also referred to as being "in Contango".

Now lets pretend for a second that there is a big fire at one of the Cotton warehouses that holds a decent sized percentage of the cotton that is currently available for sale. As a decent sized chunk of the cotton currently available for sale has just been destroyed, this creates a shortage of Cotton. As the basic laws of supply and demand show, anytime you have a decrease in supply and demand stays constant, price should rise. As the fire that destroyed the cotton is presumably a one time event however, it also makes logical sense that the supply disruption should affect the prices of the futures contracts which are closest to settlement the greatest, and the ones farthest away the least. A situation where there is a near term supply shortage such as the one we have just described, can cause the prices of the contracts closest to settlement, to rise above the contracts furthest away from settlement, which would look something like the following:

March 09 Contract: $55.00
June 09 Contract: $53.50
July 09 Contract: $52.00
October 09 Contract: $51.00
December 09 Contract: $49.19

When we plot these prices on a graph, instead of being an upward sloping or normal market, this market is now downward sloping. Like upward sloping markets are called normal markets, downward sloping markets are called inverted markets. In this example, because prices for futures are below the current spot price, the futures prices will converge towards the spot price from below as we move closer to settlement. The process of prices moving towards the spot price from below is what is known as backwardation, which is why you will also here inverted markets referred to as being "in backwardation".

That's our lesson for today. You should now have a basic understanding of the terms normal market, inverted market, contango, and backwardation. In our next lesson we will continue our look at what the relative prices of futures contracts with differing settlement dates can tell us about the market, so I hope to see you then. As always if there are any questions or comments please leave them in the comments section below, and good luck with your trading!

Links to Help You Learn About Contango, Backwardation, and the Futures Curve

Contango Vs. Normal Backwardation
Contango - Wikipedia, the free encyclopedia
Futures Curves - Magic's Blog

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Old 02-27-2009, 09:08 AM   #2 (permalink)
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Contago etc...


Great lesson.
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Old 06-03-2009, 01:10 AM   #3 (permalink)
 
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spot price


Hey David!

Great to watch these vids for real!!! My question is simple yet obviously VERY IMPORTANT based upon your videos, and I haven't heard the answer to it YET. How do I know what the spot price is for any given instrument? And where do I find it online and do I have to pay for that information?

Thank you so much for this great RAW DATA and unbiased INFORMATION to trading. It is SOOOO HELPFUL...and oasis among wolves.

rock on.

MT.
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Old 06-04-2009, 10:14 AM   #4 (permalink)
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Hi MT,

Glad to hear from you.

Quote:
How do I know what the spot price is for any given instrument? And where do I find it online and do I have to pay for that information?
While I think it is important for all futures traders to understand what the spot price is really only spread traders or traders who are trading the fluctuation between the spot price and the futures price pay attention to the spot price in relation to the futures.

For some instruments like currency futures there is a very active electronic spot currency market so it is very easy to get the spot price for free at a place like FXCM.com.

For other instruments like cattle the spot price is more difficult to find, because the spot market for cattle is what people are actually paying for cattle at the market. This is going to vary not only by the type of cattle that are being traded but also by the location of those cattle so unlike currencies where there is basically 1 spot price, for cattle there could be hundreds of different spot prices for cattle depending on where in the country you are.

With this in mind, for instruments like cattle where there is not 1 spot price, traders use the front month futures contract (the one that is closest to delivery) as a good estimate of where spot is trading.

Let me know if that does not make sense or if you have any other questions.

Best Regards,
Dave
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Old 06-17-2009, 12:40 PM   #5 (permalink)
 
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contract price


If 1 contract for cotton futures is $43.00. How much am I losing if say the price goes to $41.00. Is that 8 ticks and at $50 per tick= $400? Do I have that right?

I think my decimals are off, I used dollars as presented in video but the transcript and next videos shows cents, $.43 not $43.0
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Old 06-17-2009, 12:49 PM   #6 (permalink)
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Hi KPFX,

I just checked the ticksize at ThinkOrSwim and it is 5 dollar per tick (0.01).
Currently the price is at 57.62 dollar.
So if you would lose 2.00 dollar on a trade, you would lose 200(ticks) x 5 dollar = 1000 Dollar.
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Old 06-17-2009, 01:02 PM   #7 (permalink)
 
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Point vs. tick


Thanks CVD!
In an earlier lesson Dave said $50 per point for mini futures as opposed to $250 for standard futures contracts being a benefit of emini futures. I am not understanding some thing.
A tick is .25 correct? If so, then what is a "point" at $50?
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Old 06-17-2009, 01:09 PM   #8 (permalink)
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Quote:
Originally Posted by KP FX Trader View Post
Thanks CVD!
In an earlier lesson Dave said $50 per point for mini futures as opposed to $250 for standard futures contracts being a benefit of emini futures. I am not understanding some thing.
A tick is .25 correct? If so, then what is a "point" at $50?
It depends on the contract, some contracts have a ticksize of .25 like the S&P Emini (which is 1/5th of the 'normal size' S&P futures contract dave was talking about). So in case of the Emini S&P 1 point equals 50 dollar, and 1 tick is .25 point, so 1 tick equals (50/4) 12.50 dollar.

Other markets may have different ticksizes and point values, like the russell2000 has a 0.1 ticksize which equals 10 dollars, so 1 point in that market would be 100 dollar.

here is some info on the ticksize of most markets: https://www.thinkorswim.com/tos/disp...t=hide#futures

I would advise you to open a demo account (i prefer thinkorswim) and download the platform, that way you can get a better understanding how the markets work and see the different ticksizes in action on the Market-order-ladder.
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Old 05-29-2012, 10:25 PM   #9 (permalink)
 
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David,
Thanks for offering these lessons. You are very good at this! I understand that commodities need the futures exchange to stabilize price for the farmers and the companies buying the commodity. But, how does that parallel to the financial futures? Why is price stability needed for the financials when there is options on the indexes.
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