Contango

Gold Contango: One of our recent portfolio trades was a "contango" - where you believe that the price of a commodities future is higher than it should be (meaning it is higher than you think the "spot," or quoted, price will be in the future). 

One of the underlying terms in buying/selling futures is the idea of the "spot" price versus the "futures" price.  The spot price is simply the price of a security at any given time. The futures price is the expected price of a security, which is estimated using the spot price and the future time frame.

Generally, people are willing to pay more for a commodity in the future than they are now, since buying later saves them the cost of transporting and storing whatever the commodity is (grain, soybeans, oil, etc).  This means the future/forward price is generally higher than a spot price to buy today, but as the future contract nears its maturity date, the price will drop to the current spot price (theoretically).

Making money on this strategy is a contango trade: Say an investors determines that the price right now to buy gold in 12 months is much higher than the actual price to buy gold in 12 months will be.  The investor essentially expects the value of the 12 month contract to decline over the course of the 12 months, so the investor shorts the 12 month contract. In order to protect themselves against general movements in the price of gold, the investor also goes long the current spot price (i.e. 'buying' gold at today's price, and betting that the value of the contract to buy gold in 12 months will decrease).

Still sound confusing? Perhaps a Wikipedia graph will help - essentially we see the forward/future price declining for a given contract over time (as it gets closer to delivery date). By shorting the future/forward, the investor makes money.

Of course, this all depends on the rather giant assumption that no macro economic (or other factors) will cause the value of gold (or whatever other commodity) itself to change.  If the perceived value of gold changes, it can throw off both the spot and the forward curves, making it difficult to profit.

The opposite of a contango is a "backwardation." This is where the future price is perceived as too low compared to the current spot price. The strategy here would be to short the commodity at today's price, and go long the futures contract.

Short Euro/USD: One of our other macro trades recently was to short the Euro in EUR/USD futures contracts. This happened to be very profitable since the trade was put in right before the Italian election, whose results brought a group of anti-austerity politicians to power.  Seen as a blow to Euro-zone economic stability, this weakened the Euro.  The trick with currency and commodities trades is that movements can be quick and rather fickle; once profitable, we closed the position (thankfully, since the Euro since started to rally  bit).

If none of the above spot/future babble made sense (or worse, put you to sleep), at a bare minimum you can now impress (or frighten) your friends at cocktail parties by throwing out the term contango.  Heteroscedasticity is also a fun one, but that's a story for another post...