The solution to contango blues?

One of the well known secrets of commodity trading is the gains from backwardation. Because back month futures are usually priced below the current spot price, buyers of futures receive a risk premium or compensation for futures convergence. The traditional story is that long speculators are compensated for taking on the risk of short hedgers. If a commodity market is in contango, the futures price is higher than the spot price. Convergence of the basis or price difference will lead to a decline in price. If you are long the futures there will be a drag on performance.

A number of reasons or effects cause backwardation or contango. It could be that futures have a risk premium. There is also the issue of convenience yield for holding a cash commodity. The cost of carry is also a consideration. Overall the difference between cash and futures will change over time as the economic environment changes, so investors cannot bank on normal backwardation or return for trading against hedgers. Unfortunately, it is hard to tell when the market will prefer to be in backwardation. It is the view by some that determining the cash futures basis may be easier than the outright direction, but research suggests that they would be wrong. While the futures basis is less volatile than the futures price, the returns for trading this basis is also lower and may not be more predictive.

A solution is to trade different maturities to reduce the drag from contango and maximize the effect of backwardation. All things equal, you would like to be long the contracts which have the most backwardation and try and avoid or minimize the effect of contango.

S&P has introduced a new GSCI forward index which tries to alleviate some of the negative effect of contango. This is the second index that has been developed in the last two months to trade contracts further from maturity in an effort to minimize the effect of backwardation or contango. This contract should do well during those periods when the market is in contango, albeit most times the most liquid commodities like crude oil are in backwardation.

Adding more indices provides investors with more choices, but it also adds more confusion to the commodity index market. The choice of index becomes even harder. You become an active manager through making your index choice.