Learn About Fundamental Analysis with a Complimentary Intro Guide from RJOFutures

RJOFutures’ Intro to Fundamental Analysis Guide provides vital information on which related economic, financial, and other qualitative and quantitative factors can be used to evaluate commodities in the agricultural, soft, metal, and energy markets.

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Contango:

According to Investopedia, a contango market is often related to a normal futures curve. A normal curve refers to a snapshot of the various futures prices increasing in value as time goes by. The table below illustrates a normal or contango gold market. Notice the increasing prices as the time to maturity increases in the “Last” or “Prev” columns.

The increase in value is easily explained by the cost of carry, which typically includes the cost of interest, insurance, and storage for owning a commodity. In the financial world, it typically refers to the cost of interest or time and margins. In other words, if you own or go long the commodity, you have to “pay” for the cost of carry. When you roll your position, you have to pay the cost of carry by buying the further out contract at a higher price than where you sell the nearby contract. If you are short the contract, you are essentially being “paid” the cost of carry when you sell the deferred contract at a higher price than the nearby contract. The steepness of the curve is also an indicator of expected supply and demand tightness. If the contango curve becomes steeper, the market is telling you that the longer-term supply and demand situation is expected to increase—which translates into a very bullish scenario. With a steeper curve, you would be paid a higher cost of carry, due to higher risk or increasing supply and demand tightness. Hedgers in need of owning a product would likely benefit from locking in future supply. It is also believed that the spread relationship will likely tighten over time, because the difference between the futures and cash market (also known as basis) converges at expiration. If the futures and cash market do not converge, an arbitrage opportunity would exist. If the market trades in contango—especially a steep contango—the cash price will likely rally more aggressively, relative to the futures price over time. Therefore, if you buy nearby contracts and sell further out contracts, the odds of successfully trading spreads increase in contango markets.

Backwardation:

A market in backwardation is often related to an inverted futures curve. The nearby contracts are trading at higher prices than the deferred contracts. This occurs during a current tight supply and demand situation and is favorable for market sellers over time, as the tightness subsides. The table below illustrates an inverted crude market. Notice the declining prices as the time to maturity increases.

In this market environment, it doesn’t pay for companies to buy and store the physical commodity, because they can purchase it at a lower price in the future without paying the cost of carry—according to the curve making this scenario favorable to market sellers. In this market scenario, it makes sense to see domestic stocks actually tighten in the weekly American Petroleum Institute/Energy Information Administration (EIA) energy stocks, because it is favorable to the consumer not to store excess supplies. The market generally interprets the reports as bullish and causes volatility to increase in the short term. The increase in volatility is indicative of a near-term topping action as well. Just as the steepness of the curve in a contango market tells a story, the opposite is true for markets in backwardation. In this scenario, it is also believed that the spread relationship will likely tighten over time and the basis will converge toward expiration. If you sell nearby contracts and buy further out contracts, the odds of successfully trading spreads increase in markets in backwardation.

Understanding the longer-term curve of the market can help in making educated hedge and speculative trading decisions. However, it is also important to understand that only following the contango and backwardation of a market is not a foolproof indication of a higher or lower longer-term market. According to the EIA, the energy market supply and demand situation is being driven by many factors—including strong economic growth in countries such as China, potential worldwide refining bottlenecks, ongoing geopolitical risks, and Organization of the Petroleum Exporting Countries production decisions. All of these factors have contributed to the current market backwardation or current tight supply and demand. If any of these factors warrant a threat of a further tightening supply situation, the curve could steepen rather than flatten out.

The risk of loss in trading commodity futures and options can be substantial. Before trading, you should carefully consider your financial position to determine if futures trading is appropriate. When trading futures and/or options, it is possible to lose more than the full value of your account. All funds committed should be risk capital. Past performance is not necessarily indicative of future results.

Donna Heidkamp
Sr. Trading Advisor, RJOFutures

My interest in the futures industry stems from strong family ties to production agriculture in Hereford, Texas. After completing a bachelor's degree in Agricultural Economics at Texas Tech University in 1995, I moved to Chicago to participate in the Chicago Mercantile Exchange Agricultural Broker Training Program. The program exposed me to all facets of the futures industry, enabling me to work with experienced floor traders and develop a strong understanding of the intricacies of trading in the futures markets.

Since completing the training program in 1995, I have continued to gain a well-rounded knowledge of the industry by working as an order clerk, trading desk manager, and broker for RJOFutures. In 2004, I started a branch office of RJOFutures to focus my efforts on helping clients meet their trading goals. By identifying client objectives, managing risk, and providing a carefully tailored service, I serve as a dedicated liaison on all trading floors to full-service, broker assist, and on-line clients. My commentary can also be heard regularly on CNBC TV and Bloomberg.

In order to continue to better serve my customers in an ever-evolving and dynamic industry, I also completed a M.S. degree in Financial Markets and Trading from the Illinois Institute of Technology in May of 1999.

RJOFutures is the retail division of R.J. O'Brien, one of the oldest FCMs tracing its history back to 1914.