Friday, January 27, 2012

Origins of contango and backwardation

We often use terms without understanding their origin. I recently had a question on the origin of the contago and backwardation. Their origins are not related to futures trading at all.

The term originated in mid-19th century England[12] and is believed to be a corruption of "continuation", "continue"[13] or "contingent". In the past on the London Stock Exchange, contango was a fee paid by a buyer to a seller when the buyer wished to defer settlement of the trade they had agreed. The charge was based on the interest forgone by the seller not being paid.

Like contango, the term originated in mid-19th century England, originating from "backward".
In that era on the London Stock Exchange, backwardation was a fee paid by a seller wishing to defer delivering stock they had sold. This fee was paid either to the buyer, or to a third party who lent stock to the seller.
The purpose was normally speculative, allowing short selling. Settlement days were on a fixed schedule (such as fortnightly) and a short seller did not have to deliver stock until the following settlement day, and on that day could "carry over" their position to the next by paying a backwardation fee. This practice was common before 1930, but came to be used less and less, particularly since options were reintroduced in 1958.

No comments: