In the any futures market there are several delivery months offered at the same time. As an Example, you can sell or buy gold for delivery in September or December of this year, March of next year as well. Typically the closer months are less expensive than the further out months, and that relationship is commonly referred to as contango market.
You will also hear a so called cost of carry which is higher for further dated contracts as it relates to the cost of financing, insuring and storing the actual commodity. Most futures buyers can put down his margin requirement and control the contract without having to bring the rest of the money until the futures contract settles. On the flip side, the seller has to insure, store and finance the gold, oil, wheat or whatever the commodity is.
When you hear of premiums it is referring to the difference between delivery months. Trades who hedge and actual floor traders watch these premiums closely because they reflect the degree of tightness in the market. When supply is tight or demand rises, traders start paying up for nearby months. As a result the premium further dated contracts shrinks. As the demand grows, the closer dated futures contracts become more expensive that the further dated ones and as a result the markets invert. This is typically one of the fundamental signs of a bull market. It shows that there is a shortage in supply and that futures traders are willing to pay extra to get their material sooner rather than later.
Contango and Backwardation
The next time you’re looking at futures contracts online or in the paper look at the closing prices and search for backwardation. As a technical trader it signals for buying opportunities and take long positions in those particular futures contracts.
For firms that hedge all the time they do not wait for backwardation. They monitor premiums and get the buy indicators from the tightening of widening of them. That is why floor traders have the best ability to pick these signals up. Any speculator will run off the latest price but a trader who is hedging will tell you the latest premium of the furthest away futures contract over the closer ones.
There is one caveat for this. As you scan for market backwardation there is one area where it is normal. Interest rate futures are continuously inverted since the person holding the cash position keeps collecting interest instead of paying for stocking and finance charges
