Introduction to futures: forwards, contango, backwardation.

By roma, 17 August, 2020

Futures contract - a standardized agreement between two counterparties to buy or sell an underlying asset (security, goods) at a price agreed in advance at a specified future date. The contract specifies the quality and quantity of the underlying asset. There are two types of futures: delivery and cash-settled.

Futures obliges counterparties to meet the terms of the agreement: to deliver/buy the underlying asset in the event of a delivery contract, to pay/receive the difference between the contract price and the spot price during the expiration. Unlike forwards, futures contracts are traded on the stock market, thus providing market participants with greater liquidity.

Futures can be used both for hedging and speculation. For example, an oil producer can use a futures contract to fix the selling price of oil, which will reduce the volatility of profits. On the other hand, an investor can buy/sell a futures contract to profit from the price movements of the contract.

 

The difference between futures and forwards

Forward contract – an agreement to buy or sell a security, commodity or currency at an agreed price with delivery on a specific date in the future. A forward is a legal agreement between two parties that is not traded on an exchange, but is executed on the OTC market as opposed to a futures contract that is an exchange contract.

Unlike a spot contract which serves as an agreement to buy/sell an asset at the time of the transaction, obligations on a forward are fulfilled on a specific date in the future. For example, one party to a forward contract takes a long position and agrees to buy the underlying asset on a certain date for a certain price. The other party takes a short position and agrees to sell the asset on the same date for the same price.

 

Contango

Contango - the situation at the futures market, when the price of a futures contract for the coming months is cheaper than for contracts with a longer expiry date. Thus, the futures price curve has an upward slope.

Contango on the WTI oil market (May 1, 2015)
Contango

The reason for contango may be the cost of storing the goods. For example, oil production also involves storage until delivery. Therefore, the longer the oil is stored, the higher the costs and the higher the futures price for later months.

Backwardation is the opposite situation to Contango.

 

Backwardation

The situation on the futures market, when the price of a futures contract for the coming months is more expensive than for contracts with a later expiry date. Thus, the futures price curve has a downward slope.

Backwardation

Backwardation occurs when the difference between the forward price and the spot price is less than the cost of maintaining an investment position. Backwardations are typical for commodity markets.

For example, because of cold weather, power plants need to generate more electricity. As a result, the spot prices for gas and coal should increase significantly, while the 6-month futures prices may remain unchanged, as warm weather is expected in 6 months.