Backwardation & Contango
Backwardation is when the price in the spot market is greater than the price in the futures market. Generally indicates scarcity.
Contango is when the future price is greater than the spot price. Implies that there is plenty of the good available, or at least that there is no scarcity.
Basis & Cobasis
Let’s start with an oversimplified definition.
Basis = Future – Spot
Cobasis = Spot – Future
What we are trying to see is a measure of scarcity. If the price in the spot market is higher than in the futures market (e.g. grain, one week before the harvest) then the good is scarce. If the price in the futures market is higher, then anyone can “carry” the good at a profit. To “carry” means to simultaneously buy the physical good and sell a futures contract against it. A positive basis means this is profitable.
A positive cobasis means that it is profitable to “decarry”: to simultaneously sell the good in the physical market and buy a futures contract. Both carry and decarry result in the same position at the end of the day plus the profit from the spread.
To be precise, we must define these terms in a more complex way. Of course, to buy something one must pay the “ask” or “offer”. To sell, one must accept the bid. With that in mind, here are the correct definitions:
Basis = Future(bid) – Spot(ask)
Cobasis = Spot(bid) – Future(ask)
Note that both can be negative (which often occurs as a contract is heading into expiry and there is no liquidity, hence the bid is very low and the ask is very high). At most one of them can be positive. It can be profitable to carry a good, or to decarry it. But it makes no sense for it to be possible to carry profitably and decarry profitably!
Think of the futures market tied to the spot market via a spring. As speculators push up futures, the spring pulls up the price of metal in the spot market. But the tension on the spring increases. The basis is the measure of the spring tension.
Carry & Decarry
Carry involves buying a commodity and selling a futures contract against it. One pays interest on the money one borrowed to buy the commodity and one has costs to store and insure it in the meantime. For the trade to be profitable, the futures price needs to be higher than the spot price (contango) by an amount greater than the costs of carry.
Decarry involves selling a commodity and buying a futures contract against it. For the trade to be profitable, the spot price needs to be higher than the future price (backwardation).