Your commodities dictionary
What does futures pricing look like? Brace for jargon. Commodities investors talk about the “futures curve” mapping out the prices today for contracts that settle on different dates in the future. Normally, the curve slopes upwards: the price of oil two months from now would be greater than its “spot price” today. That’s because the seller of the contract has to be paid for the storage of the commodity for those two months, and compensated for having to wait two months for their cash. In these situations, traders say the curve is… normal (they’re an imaginative bunch).
But when it’s cheaper to have the commodity delivered two months from now than to get it today, we have the opposite inverted curve sloping downwards. A temporary shortage of beef, for instance, would drive up the price for today’s cows while leaving the price of future cows the same 🐄
And how do these prices change over time? Futures contracts let you buy something for a set price in the future – but that doesn’t mean that the price you’re paying today for a January 21st delivery is the actual price you would pay on January 21st (think about how pre-order prices for games or books sometimes differ from release day prices). If the curve is normal, the futures price might be higher than the expected “buy-it-now” price for January 21st. If that’s the case, we say the market is in contango – people expect the price of the futures contracts to fall over time to meet the expected “buy-it-now” price.
The opposite is when the market’s in backwardation. That’s where the futures price is below the expected “buy-it-now” price for January 21st, which signifies that people think the price of the futures contracts will rise over time: they think the price in a month is going to be even higher than the futures contracts are suggesting it is. Markets that are in backwardation are perfect for long-term investors, because they’re holding onto an asset that’s increasing in value.
Be warned: traders sometimes use these terms interchangeably. The two concepts are subtly different: normal and inverted refer to today’s snapshot expectation of the future, reflected in the cost of futures contracts for different dates to come, whereas contango and backwardation are analyses of how prices of the underlying commodity will actually move over time ⏰
Now you know the jargon, let’s get to the fun – how to actually trade commodities.
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