Hedging with Jorge #Episode23: A beginner’s guide to futures trading

In our previous session, we explored how borrowing works in a contango market. Let’s quickly recap and then shift our focus to backwardation.

Contango Recap: In a contango scenario, the price of a future contract for a later date is higher than the price for a nearer date. Here’s how it works:

Borrowing in Contango: You buy the near-term contract (at a lower price) and sell the longer-term contract (at a higher price).
Short Position Roll Forward: If you’re short in April and want to postpone to June, you buy April and sell June. The contango curve allows you to profit because the purchase price is lower than the selling price.

Enter Backwardation: Now, let’s imagine we’re in a backwardation curve. What does that mean?
Backwardation occurs when the price of a future contract for a later date is lower than the price for a nearer date.

Key Differences in Backwardation:

Higher Near-Term Prices: In our example, the April price is higher than the June price.
Borrowing in Backwardation: If you buy at the higher near-term price (April) and sell at the lower future price (June), you incur a loss.

Managing Positions in Backwardation: If you’re starting with a short position in April and need to extend it to June, here’s what happens:

Close April: Buy the short position in April to neutralize it.
Open June: Sell the position for June, establishing your new short.
Impact of the Curve: In contango, this roll-forward makes money. In backwardation, it results in a loss.

Final Thoughts: The fundamental takeaway is simple:

Contango: Borrowing earns you a profit.
Backwardation: Borrowing leads to a loss.

Stay tuned for the next session, where we’ll dive deeper into more advanced concepts in futures trading.