Mechanics and Dynamics of Charting
is of course an informal use of the terms, but nevertheless, it is common practice
among futures traders. See Figure 3.34 for an example of this popular definition
of simple contango.
We observe the further‐out gold contracts trading at successively higher prices
when compared to the nearby December contract. Although we observe simple
contango, the contracts may or may not be in normal contango, which requires
some knowledge of the expected or estimated spot price at expiry, in order to de-
termine if normal contango actually exists.
One important aspect about futures contracts is that futures prices always
converge to the spot price at expiry. Hence, if a contract is in contango, and as-
suming that the spot price remains constant, it will eventually decline in price,
experiencing negative yields as it converges toward the lower spot price at expiry
or maturity. Conversely, if a contract is in backwardation, it will eventually rise in
price, experiencing positive yields as it converges toward the higher spot price at
expiry or maturity. Hence, in certain situations, especially with some mispricing,
it may be possible to long a far out backwardated contract and simultaneously
short a nearby contract, gaining from the convergence as expiry approaches, ir-
respective of the future direction of price. In short, a gain is locked in without
any directional risk involved. Again, profitability depends on the spread and ag-
gregate trading costs accumulated over the period of convergence, toward expiry.
See Figure 3.35.
Figure 3.36 is an example of contango eroding returns in the Natural Gas market
during 2009. Natural gas experienced a tremendous rally throughout 2009, which
was not matched by the U.S. Natural Gas Fund which tracks natural gas prices via
futures contracts. Although the market was rising, rolling over at relatively largefigure 3.34 Simple Contango Observed on the Daily Chart of 2012 Gold Futures.
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