Entry in progress—B.P,
Contango is a term used in the futures market to describe an upward sloping forward curve (as in the normal yield curve). Such a forward curve is said to be “in contango” (or sometimes “contangoed”).
Formally, it is the situation where, and the amount by which, the price of a commodity for future delivery is higher than the spot price, or a far future delivery price higher than a nearer future delivery. This is a normal situation for equity markets.
The opposite market condition to contango is known as backwardation.
The graph to the right depicts how the price of a single forward contract will behave over its life if in contango or backwardation. A contract in contango will decrease in value until it equals the future spot price of the underlying. This is not to be confused with a contango forward curve which depicts the prices of contracts for different maturities and is upward sloping.
A contango is normal for a non-perishable commodity which has a cost of carry. Such costs include warehousing fees and interest forgone on money tied up, less income from leasing out the commodity if possible (e.g. gold). For perishable commodities, price differences between near and far delivery are not a contango. Different delivery dates are in effect entirely different commodities in this case, since fresh eggs today will not still be fresh in 6 months’ time, 90-day treasury bills will have matured, etc.
The contango should not exceed the cost of carry, because producers and consumers can compare the futures contract price against the spot price plus storage, and choose the better one. Arbitrageurs can sell one and buy the other for a theoretically risk-free profit (see rational pricing – futures).
Origin of term
The term originated in mid-19th century England, and is believed to be a corruption of “continuation”, “continue” or “contingent”. In the past on the London Stock Exchange, contango was a fee paid by a buyer to a seller when the buyer wished to defer settlement of the trade they had agreed. The charge was based on the interest forgone by the seller not being paid.
The purpose was normally speculative. Settlement days were on a fixed schedule (such as fortnightly) and a speculative buyer did not have to take delivery and pay for stock until the following settlement day, and on that day could “carry over” their position to the next by paying the contango fee. This practice was common before 1930, but came to be used less and less, particularly after options were reintroduced in 1958. It was prevalent in some exchanges such as Bombay Stock Exchange (BSE) where it is still referred to as Badla. Futures trading based on defined lot sizes and fixed settlement dates has taken over in BSE to replace the forward trade which involved flexible contracts.
This fee was similar in character to the present meaning of contango, i.e., future delivery costing more than immediate delivery, and the charge representing cost of carry to the holder.
What Does Contango Mean?
When the futures price is above the expected future spot price. Consequently, the price will decline to the spot price before the delivery date.
(Oxford English Dictionary)
[App. an arbitrary or fortuitous formation from continue.]
The percentage which a buyer of stock pays to the seller to postpone transfer to the next or any future settling day; continuation; the opposite of BACKWARDATION. contango-day: continuation-day, the second day before settling-day.
1853 N. & Q. 17 Dec. 586/2 Contango, a technical term in use among the sharebrokers of Liverpool.
1854 C. FENN Eng. & For. Funds 109 Contango is the sum paid per Share or per Cent for carrying over such Shares for a longer period than they were originally bought for, which is from one account to another.
1882 Daily News 27 July, The settlement was commenced on the Stock Exchange yesterday, and contangoes proved light.
1885 St. James’s Gaz. 25 Mar. 9/2 On Russian of 1873 stock the contango charged this morning changed to a slight backwardation.
10 April 1832, Eastern Argus (Portland, ME), pg. 2:
Half past One.—The fluctuation of this account being so trifling, no failures are expected to take place, but money is scarce in the House, and it is a Bull Account with 5-16 contango.
11 April 1832, True Sun (London), pg. 4, col. 4:
The operations in the Funds have been almost exclusively confined to the adjustment of Accounts, and hitherto the settlement has gone on quietly. The early part of the morning Consols were alternately buyers and sellers at 83 1/2 with a continuation of about 5-16 for the Money account. About one o’clock, however, the balance appeared to be turning in favour of the Bulls, which had the effect of advancing the price of money to 83 5/8, and reduced the contango, as it is technically called, to one-eighth.
12 January 1839, Connecticut Courant (Hartford, CT), pg. 2:
Another cause for this scarcity has arisen out of the late demand for stock, which being borrowed at a low centage, and now that the contango has been considerably advanced, has caused much money stock to be thrown upon the market and a consequent reduction in the quotations of Consols.
18 December 1847, Southern Patriot (Charleston, SC), pg. 2:
[From the New York Courier.]
The British National Debt—British Consols.
LONDON, 18th Nov. 1847.
Each account is opened for transaction about ten days before the predecessor closes so that parties wishing to postpone the settlement of their contracts to the latter date can do so by paying a certain difference of price which established itself in the market, and is called a “contango” or “continuation.” This contango is now as between the present and the January account about 5/8 of one per cent.
28 January 1854, Household Words, pg. 522, col. 1:
The terms Contango, Backwardation, and Continuation, are applied to arrangements connected with Time Bargains. The Contango is the rate of interest (generally about three-sixteenths per cent.) incurred by a buyer to postpone payment until the next settling day, when he has not the means or the inclination to pay for it at once. For instance: taking the price of the day at which the bargain was made at 94 3/4 for the December account, the buyer has three-sixteenths per cent. added to this quotation for the accommodation of deferring actual payment for the stock until the settling day in January. Backwardation reverses the transaction. In that case, the buyer receives a per-centage on the condition of not compelling the seller to deliver the stock at the next day of reckoning, but to retain possession to the succeeding account, or for any other future day agreed upon. The Continuation consists of an additional percentage paid by either party for keeping open the transaction, should he not be in a condition to close it at the time specified when the barain was struck. These, and all other incidents of Time Bargains, are rank gambling.
13 August 1889, Wall Street Daily News, pg. 1:
In reply to several inquiried as to the meaning of the word “contango,” as used in our article in yesterday’s issue entitled, “Will be a Factor,” we will state that it is a term used on the London Stock Exchange. Frequently an arrangement is made in that Exchange to continue shares, viz., postpone delivery or payment until the next settling day, which is performed by the payment of a premium called in the case of the seller “backwardation,” in that of a buyer “contango.” But, practically, the terms “backwardation” and “contango” mean that a new operation is begun each settling day, because the loss is settled and paid by the client on each of those periods.
Dictionary of Political Economy
By Sir Robert Harry Inglis Palgrave
New York, NY: Macmillan and Co.
CONTINUATION OR CONTANGO. Under the word BACKWARDATION (q. v.) the process by which a person who, being unable to deliver stock which he has already sold, borrows it, has been already described. In the same way, one who has bought stock or shares which he cannot pay for is obligated to borrow the money, and this he can often do from the person who has sold the stock or securities in question. But the seller charges him a “contango.” Under normal circumstances the contango, or rate of continuation, somewaht exceeds the ordinary rate of interest at which money can be borrowed from the banks, for the banks do not lend to the full market-value of the securities lodged with them, whereas one who “contangoes” retains securities to the bare amount of his loan, and has no claim until the next settling day against the person whom he trusted to fulfil the bargain. A great deal of business is done by money dealers, who borrow at a low rate and re-lend on the stock exchange in this way. A. E.
New York City • Banking/Finance/Insurance • Monday, November 22, 2010 • Permalink