Contango As A Gold Mine And Why Should Bitcoinists Care

Allegedly Albert Einstein said: compounding interest is the most powerful force in the universe. Or, may be, not, see here. But the interest are playing a huge role in investing, and I’m afraid the brave new crypto-world will be no exception either.

Double pain, double gain

If you are investing your own money, the game is simple: you win, if prices go up, and loose, if prices go down. (But you should consider also the inflation rate.) If you are investing with the capital of others, with the money coming from loans or credits, and are wining, but not enough, you also loose. If you are gaining, but gains are inferior than the interest you pay, bad luck.

Investing with debt is more difficult because you have to win more to be profitable. Dangerous, because if you loose, you loose more, with the interests and you can be liquidated.

Hidden interests

You find interests on places where you don’t expect it. For example, hidden in futures prices: commodities, indexes, and, yes, also by Bitcoin futures. Buried in the price differences of the futures settlements. This is called contango or backwardation.

For example. You have 10 tons of any food, and you need money. Somebody gives you a loan, but only if you put your commodity in pawn. You make a contract: you sell now your goods for 10 000 dollars, and you can buy it back for 11 000 in the future.

Who pays the costs?

That means practically, you got a credit with 10 percent of interest you have to pay. The future price of your food is 11 000 USD, and the prompt (present, cash) price 10 000. We could say that the price of this products is in contango, because the futures price is more elevated than the prompt price.

Contango is a situation where the futures price of a commodity is above the expected spot price… people are willing to pay more for a commodity at some point in the future than the actual expected price of the commodity. This may be due to people's desire to pay a premium to have the commodity in the future rather than paying the costs of storage and the carry costs of buying the commodity today. Investopedia

Get paid for taking loans?

Something similar happens many times on futures exchanges, but sometimes futures are lower than prompt prices. Imagine, you can sell your goods for 10 000, and buy it back for 9000. You gain 10 percent, and they pay you for taking a credit? Yes, this can also happen on exchanges. (“The game of all games” – capital markets can be very exiting, by the way.)

This second case is called backwardation, that means that futures prices are below the prompt prices. That can happen for example if the market is expecting a price fall. In some cases that has a special reason, for example, live lean hogs prices are topping mostly in May-June, in the barbecue season, and are falling after that. This often causes a backwardation, almost every year.

Prices must converge

Natural gas prices, many times are topping in winter months, in or before the high heating season. Or simply if market actors are pessimistic about the future price of something.

Contango or backwardation, the futures and spot price must some day converge until expiration. By backwardation, the future's price rises toward the spot price, or spot price decreases. By contango, futures price must fall or prompt price must go higher (or both).
See also Investopedia

The mythril case

And here is the important point. Back to an example. Let’s suppose the prompt price of mythril ore (an imaginary metal in fantasy games, worlds) is by 10 000 USD, the first month futures price, 11 000, and the second, 12 000. (A huge contango.) You buy mythril futures for 11 000 and wait. In a month, prices don’t change.

So, after 30-31 days, mythril prompt will be 10 000 only, so you loose 1000 USD from your 11 000. The second month futures is the first now and is 11 000 worth, also down 1000. If you want to prolong, maintain your trade, you must buy again at 11 000 (roll your position over).

Stay on the bright side

Then, if prices basically don’t go anywhere, again, you loose 1000 again in an other month. As if you were paying a terrible loan with 10 percent of interest every month.

What the one looses, the other wins. In this case, if you are not a buyer, but a seller – you are shorting mythril – you gain the same money! This is for you like a bond that pays 10 percent of interest every month. But remember, only if prices, the price structure don’t change, or not very much.

In the situation of a backwardation, the buyer (long position) gains and the short seller looses. The same, but inverted.

In real life?

Is this possible in real life? Yes, sometimes. I couldn’t find 10 percent a month now, but today there was a 6,6 percent of difference between the August and July futures of the VIX volatility-index. A huge contango. (Annualized: 79,2 percent, with linear calculation only.) And the crude (WTI) oil had a 1,7 percent of backwardation between October and September, 20,4 percent annualized.

Income hunting

Many commodity players are trying to find something with high backwardation or contango, to get interests-like income. But the markets are not stupid. This anomalies, price differences are having mostly some reason, as I indicated by the lean hogs and natural gas. Contango and backwardation itself means no guarantee to success, but makes the game much more interesting, shifts the chances of winning to some side and have to be considered carefully.

Just like oil or other commodities, Bitcoin is traded on the exchanges Cboe and CME. (I Wrote about the trading two weeks ago.) But at this time, Bitcoin futures prices are showing almost nothing of contango or backwardation.

In the future, and with an increasing trading volume, this can be an important factor. If greater contango or backwardation shows up, arbitrage-hungry speculators ‘ll come to the market and push volumes up, shift prices. It can influence also the spot prices. Don’t forget contango and backwardation.

Disclaimer:

I am not a financial advisor and this content in this article is not a financial or investment advice. It is for informative purposes only, or simply to make you think, entertain, increase testosterone and adrenaline level. Consult your advisers before making any decision.

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