QUESTION: COMPARE Contango and Backwardation . INCLUDE EXAMPLE of each to clarif

Question

QUESTION: COMPARE Contango and Backwardation. INCLUDE EXAMPLE of each to clarify your explanation. Please give full expalanation.

NOTE: Terminology is key, and will hasten your understanding. Try to avoid using the concept of a future spot price, because by definition, it is unknowable. Spot is and can only be now. TRIKE price is the only knowable price in the future, because it is specified in a contract. Lastly, don't confuse the strike price (for the underlying, at a specified quantity) for the price of the contract, which we have yet to discuss.

Another important note: I will not read/give credit for word or PDFs attachments or graph attached.

I WANT ANSWER DIFFERENT FROM THIS: Contango: markets in which futures prices are higher than cash prices are said to be contango

Backwardation: markets in which futures prices are lower than cash prices are said to be in backwardation

Normal backwardation is when the futures price is below the expected future spot price. This is desirable for speculators who are "net long" in their positions: they want the futures price to increase. So, normal backwardation is when the futures prices are increasing.

Explanation / Answer

The Contango and Normal Backwardation is a concept related to futures contracts where a buyer and seller come to an agreement to sell or buy a specified commodity at a specified price through standardized exchanges.

Functioning of futures:

Futures contracts are the contracts which are standardized by the exchanges to offer a facility for the buyer and the seller to transact with each other without any default by the counter party at the time of expiry of the contract. In fact, the contracts are traded based on demand and supply. So, in any manner, if the buyers dominate during the contract period, it will have a positive effect on the price in future. At the same time if the sellers dominate during the contract period, will result into the negative effect on the price in future. Ultimately, both buyers and sellers settle at one price where they agree to exercise the contract at time of expiration.

Contango: It is the state of futures contract where buyers are dominated and hence it indicate the more in value and reflects higher prices in futures. But, at the time of expiration, all the trades are supposed to be exit. During this process, the buyer dominated market looks like seller dominated market and it’s come down to the exercise price.

Example: A June 2016 Futures contract of a crude oil is trading at $80 with an expiry at $85 on or before June 30th. 2016. After some time, the buyers are dominated in the contract. In this case futures prices will increase and suppose that the futures are trading at $90. Suppose, the same is continued till the expiry date, then at the time of expiry, the buyers will cover the positions to exit trade. This concept is technically known as “Contango”

Normal Backwardation: It is the state of futures contract where sellers are dominated and hence it indicates the less in value and reflects lesser prices in futures. But in the case of Normal Backwardation, at the time of expiration, all trades are supposed to be exit. During this process, the sellers will exit from their trades and covers the positions. This leads to the appreciation of price of the futures and its go high to the exercise price.

Example: A June 2016 Futures contract of a crude oil is trading at $80 with an expiry at $85 on or before June 30th. 2016. After some time, the sellers are dominated in the contract. In this case futures prices will decrease and suppose that the futures are trading at $70. Suppose, the same is continued till the expiry date, then at the time of expiry, the sellers will cover the positions to exit trade then prices of futures will increase. This concept is technically known as “Normal Backwardation”.

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