We have really learned a lot in the past ten parts of our series on commodity spreads. We already understand what spreads are, how are they traded, and how to build your own strategy based on the current market situation. Great. Today I am going to explain a slightly more advanced thing that I use very often in my trading – contango histogram.
Small glossary at the beginning
When we talk about contango in general, we can think about both contango and backwardation. Contango generally refers to the market structure and it is calculated, similar to bear spreads, as the difference between the price of the more distant contract and the closer contract divided by the price of the closer contract. For example, for the first two expiration months, it is counted as (F2-F1) / F1. Consequently, the contango is positive if the more distant contract (F2) is more expensive than the closer one (F1). Such a state of the market is commonly referred to as contango.
The opposite situation is a negative contango, for example, when the F2-F1 difference is negative. The first expiration month is therefore more expensive compared to the more distant one. This state of the market is referred to as backwardation.
And now we can start with the contango histogram. Horizontal axis represents a contango rate. First, we need to find a zero that is represented by the lighter blue color. To the right of the zero, the market was in contango and on the left from zero in backwardation. The vertical axis of the chart then represents the frequency in days. It is basically very simple. The value of each column on the vertical axis tells us how many times the market between the two displayed contracts was at a certain state of contango over a period of time. This means that the higher the column is, the more often the market was in the given state. And vice versa.
The following chart shows the contango histogram for corn, namely the combination between the first two expiration months for the past 15 years.
Thus, the Contango histogram shows the distribution of the contango for the last year, 5 years, 15 years, etc. It is an excellent tool because it is obvious at first glance in which state the market occurred the most. And that’s very useful information for us as spread traders.
However, a vertical color line is very important here. It simply highlights the current contango rate. Thanks to it, we can compare the current state of the market with historical data. At first glance, we can see if the market is in the normal state and there is nothing exceptional, or the market is in an extreme position.
This is not all what SpreadCharts application offers when we speak about histogram. In the top left corner, you’ll also find the percentage of the contango frequency. For example, the following graph displays a soybean histogram. And we can see here that between the second and the third month of expiration, the market was in contango in 63.1% of the time over the past 5 years. Since the value is positive – contango, the rest of the time the market was logically in backwardation.
We have already explained how to correctly compile a spread. However, one question remains, how to choose between contracts in particular situation? Sometimes we have fewer options, sometimes more, but we always have a choice. And we’ll look at this next time.