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