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Dealing in the Spot Market

Dealing in the Spot Market

An effective forex trading strategy does not have to be limited to only forward contracts. At times, Trading foreign currency directly in the spot market, at the current spot rate, is the most effective strategy for a business to minimize its costs or maximize its profits. Sometimes, it can be more profitable to execute a currency exchange at the current spot rate to take advantage of favorable pricing for a product, or to receive payment immediately from a client, regardless of what the current spot rate is.

But even when transacting in the spot market, there are various tools a firm can use to maximize its profit (or minimize its loss) on the currency exchange. There are various types of trade orders a firm can utilize in a foreign currency strategy, which give flexibility in limiting the price at which it can buy or sell a currency in the spot market, to prevent surprises should prices rise or drop while the currency exchange is being executed. Some of these trading tools are briefly outlined here:

Limit Order

Limit orders are used to buy or sell a specific amount of a foreign currency at a specified exchange rate (or better). A buy limit order will only be triggered at the specified FX rate (or lower); whereas a sell limit order will only be triggered at the specified FX rate (or higher). For example, a business places a buy limit order to exchange $10,000 U.S. Dollars for Euro, but only if the Euro spot rate reached $1.10 or lower.

Stop Loss

A stop loss order protects the value of a business’s currency holding by establishing a “floor” on an acceptable exchange rate. This floor represents the maximum the business is prepared to lose on the currency trade: if the value of its currency holding declines below the floor, the holding is liquidated (sold) to ensure that the business doesn’t lose value (or if the floor is set below an exchange rate in which there is already a loss of value, it can serve to limit further losses).

One Cancels Other (OCO) Order

By combining a limit order with a stop loss order, and adding the condition that if one of these orders is triggered then the other is canceled, a one cancels other (OCO) order is created. For example, an OCO order can be used to set an upper limit order and a lower stop loss order at which a currency holding is to be sold. If one is triggered, the other is cancelled, thus the currency holding is free to trade within this pre-set range.

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What is Contango

Contango: Understanding Advanced Commodities Trading

Futures trading is all about analysing the future prices of commodities. To trade futures effectively, it is important to understand some technical terms that relate futures prices to current spot prices. One such term is contango.

Contango refers to a situation where the futures price of an underlying commodity is higher than its current spot price.

Contango is considered a bullish sign because the market expects that the price of the underlying commodity will rise in the future and as such, participants are willing to pay a premium for it now. For instance, if the spot price of gold is currently $1860, and the futures price is $1950, then the commodity is said to be in contango. 

Q&A: Is gold usually in contango? The answer is a definitive yes! In fact, most commodities are usually in contango. The premium paid above the current spot price is usually associated with carrying costs.

These are costs, such as storage or warehousing, insurance and forgone interest on money tied down to the commodity. This is a reason why commodities, such as gold, are perpetually offered at a premium in the futures market.

As the maturation date draws near, it is always observed that the forward price of gold in contango converges downwards towards the commodity’s future spot price.

The opposite is observed in backwardation, where at maturity, the forward price of gold will converge upwards towards the expected future spot price of gold.     

Contango has manifested numerous times in the markets throughout history. As a case, consider the oil price shocks in the 1970s through to the 1980s.

In mid-1980, oil was priced above $100 per barrel, but by early 1986, the price had plunged to lows of circa $25 per barrel.

In late 1998, the commodity was priced at around $14 per barrel, but it rallied all the way to circa $140 per barrel by mid-2008.

There have been more swings since then and as of December 2020, the commodity trades in the $45 – $55 range per barrel.

The above price fluctuations explain why market participants are more than willing to engage in contango in the market. It provides a unique opportunity to protect themselves from the unpredictable commodity price swings in the market that can severely puncture their bottom line.

For instance, it is common (almost standard) for airline companies to routinely purchase oil futures to bring stability in both their business model as well as their returns.

It would simply be disastrous if these companies would be buying oil at their market prices when required. These companies would likely collapse at some point. The purchase of futures contracts helps the companies to plan for stable prices for a guaranteed period.

Over the long run, the actions of market participants rebalancing their portfolios can impact asset prices. When futures contracts are bought, the increase in demand causes an increase in short term prices. But now, with the market flooded with future supply, prices consequently come down, effectively removing contango from the market.

This can naturally lead to backwardation, a situation that many financial analysts and experts believe to be the norm in commodities trading.

Backwardation is when futures prices are lower than current spot prices. This is a common scenario for perishable goods, and it leads to more demand in the future, less supply, and consequently higher prices.

But for non-perishable goods, with high carrying costs, the consensus is that they offer a great opportunity for buying call options in the futures market. This makes contango more commonplace.

Understanding Contango In Action

As mentioned, in contango, forward prices are higher than spot prices.

The opposite phenomenon is backwardation, where forward prices are lower than the spot price.

In contango, forward prices trade at a premium to spot prices mostly due to high carrying costs.

These are costs, such as storage fees, cost of financing or insurance charges. Because the opinions and perceptions of market participants (investors, traders and speculators) change continuously, forward price curves in the market can easily toggle between contango and backwardation.

A backwardation forward curve will show lower future prices and higher spot prices. This is because of the convenience yield.

The convenience yield is the benefit or implied return on holding commodities physically rather than future contracts. It is the premium derived on carrying costs.

Convenience yield exists when carry costs are low and it is beneficial for participants to hold large inventories for the long run.

The convenience yield will be low when warehouse stock levels are high and it will be high when warehouse stock levels are low.   

Backwardation can also occur when producers want to cushion themselves from the price uncertainties in the financial markets.

This is the scenario that famed economist Keynes described in his normal backwardation theory.

The theory states that sellers would be willing to sell an asset (commodities, like gold or oil) at a discount to the expected price to offset the impact of volatility in the financial markets.

For instance, a major oil-producing country may be willing to lock in futures prices that are lower than the expected prices to provide economic stability to its populace.

This begs the question: is contango really bullish or bearish? In contango, the futures prices of a commodity are expected to be higher than the current spot prices.

Still, the forward price curve will converge downwards to meet the expected spot price at maturity.

Despite this, it does not matter since contango is a bullish situation simply because the expectation of market participants is higher market prices in the future. Investors are optimistic that the prices of the underlying commodity will appreciate in the future.  

The Convergence of Futures Prices and Expected Spot Prices

The reason why traders or investors watch contango and backwardation is because of the relationship it details between futures prices and spot prices. This is important information for speculators because it will determine whether they go long or short at any given time, based on where they expect future prices to go.

The definition of contango is a situation where market participants are willing to pay a premium for the future prices of a commodity.

There are many reasons for this. They may not desire to pay insurance for the entire period, storage fees, or risk damage, theft or any other unexpected price fluctuations in the market.

But even so, at maturity, the forward price curve always converges downwards to match the prevailing spot price. If this does not happen, an arbitrage opportunity will occur in the underlying market that will basically offer “FREE MONEY” to traders.

Whether the situation in a market is contango or backwardation, the fact that at maturity, the forward prices curve converges to meet the spot price offers immense trading opportunities for speculators.

During contango, the idea will be to go long on futures contracts as the expectation is that prices will continue drifting higher. But as maturity nears, the idea will be to go short on futures contracts as forward prices converge downwards to meet the spot prices.

This will be true in the case of a backwardation situation. When maturity is still far away, speculators can go short as future prices are expected to edge lower. But as maturity nears, the idea will be to go long as forward prices converge upwards to meet the spot prices.

The conclusion is that both contango and backwardation simply reflect the opposite sides of the same coin. They also both offer exciting opportunities for both short term and medium-term speculation.

Contango FAQs

  • Is contango a bullish or bearish market indication? Contango is an indicator of bullish sentiment in the market. This is because the price of the underlying asset is expected to drift higher well into the future. Market participants are willing to pay more for the commodity in question as time goes by. A bullish market is one in which prices make higher highs and higher lows, and this is what a contango situation in the market implies for futures prices. On the other hand, backwardation is a bearish indicator because market participants believe prices will edge lower as time goes on.
  • When is contango bad? It is important to note that futures contracts have a delivery date – they cannot be held indefinitely. Consumers that want to be delivered the commodities will have no problem when the delivery date is due, but there is a concern for investors that only speculate on the underlying commodity with no intention of actually owning it. To go around this, issuers of the commodity ETF use what is known as ‘rolling’. This involves selling near dated futures and buying further dated futures of the same commodity. This allows investors to maintain exposure to a particular commodity. It is important to note though that rolling also comes with additional trading costs, both in the value of the futures contract and rolling charges. 
  • When is contango good? Contango also has its advantages. Some arbitrage opportunities may occur and this will allow traders to buy assets at spot prices and sell at future prices, pocketing the difference. In cases where inflation is rising, there is the opportunity to buy futures contracts with the expectation that prices will continue edging higher and higher as time goes by. This is an inherently risky strategy though, because it only works when prices continue to rise.
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Correct Way to Hedge

Deciding how and what to hedge requires a company-wide look at the total costs and benefits.

Hedging is hot. Shifts in supply-and-demand dynamics and global financial turmoil have created unprecedented volatility in commodity prices in recent years. Meanwhile, executives at companies that buy, sell, or produce commodities have faced equally dramatic swings in profitability. Many have stepped up their use of hedging to attempt to manage this volatility and, in some instances, to avoid situations that could put a company’s survival in jeopardy.

When done well, the financial, strategic, and operational benefits of hedging can go beyond merely avoiding financial distress by opening up options to preserve and create value as well. But done poorly, hedging in commodities often overwhelms the logic behind it and can actually destroy more value than was originally at risk. Perhaps individual business units hedge opposite sides of the same risk, or managers expend too much effort hedging risks that are immaterial to a company’s health. Managers can also underestimate the full costs of hedging or overlook natural hedges in deference to costly financial ones. No question, hedging can entail complex calculations and difficult trade-offs. But in our experience, keeping in mind a few simple pointers can help nip problems early and make hedging strategies more effective.

Hedge Net Economic Exposure

Too many hedging programs target the nominal risks of “siloed” businesses rather than a company’s net economic exposure—aggregated risk across the broad enterprise that also includes the indirect risks. This siloed approach is a problem, especially in large multibusiness organizations: managers of business units or divisions focus on their own risks without considering risks and hedging activities elsewhere in the company.

At a large international industrial company, for example, one business unit decided to hedge its foreign-exchange exposure from the sale of $700 million in goods to Brazil, inadvertently increasing the company’s net exposure to fluctuations in foreign currency. The unit’s managers hadn’t known that a second business unit was at the same time sourcing about $500 million of goods from Brazil, so instead of the company’s natural $200 million exposure, it ended up with a net exposure of $500 million—a significant risk for this company.

Elsewhere, the purchasing manager of a large chemical company used the financial markets to hedge its direct natural-gas costs—which amounted to more than $1 billion, or half of its input costs for the year. However, the company’s sales contracts were structured so that natural-gas prices were treated as a pass-through (for example, with an index-based pricing mechanism). The company’s natural position had little exposure to gas price movements, since price fluctuations were adjusted, or hedged, in its sales contracts. By adding a financial hedge to its input costs, the company was significantly increasing its exposure to natural-gas prices—essentially locking in an input price for gas with a floating sales price. If the oversight had gone unnoticed, a 20 percent decrease in gas prices would have wiped out all of the company’s projected earnings.

Keep in mind that net economic exposure includes indirect risks, which in some cases account for the bulk of a company’s total risk exposure.2 Companies can be exposed to indirect risks through both business practices (such as contracting terms with customers) and market factors (for instance, changes in the competitive environment). When a snowmobile manufacturer in Canada hedged the foreign-exchange exposure of its supply costs, denominated in Canadian dollars, for example, the hedge successfully protected it from cost increases when the Canadian dollar rose against the US dollar. However, the costs for the company’s US competitors were in depreciating US dollars. The snowmobile maker’s net economic exposure to a rising Canadian dollar therefore came not just from higher manufacturing costs but also from lower sales as Canadian customers rushed to buy cheaper snowmobiles from competitors in the United States.

In some cases, a company’s net economic exposure can be lower than its apparent nominal exposure. An oil refinery, for example, faces a large nominal exposure to crude-oil costs, which make up about 85 percent of the cost of its output, such as gasoline and diesel. Yet the company’s true economic exposure is much lower, since the refineries across the industry largely face the same crude price exposure (with some minor differences for configuration) and they typically pass changes in crude oil prices through to customers. So in practice, each refinery’s true economic exposure is a small fraction of its nominal exposure because of the industry structure and competitive environment.

To identify a company’s true economic exposure, start by determining the natural offsets across businesses to ensure that hedging activities don’t actually increase it. Typically, the critical task of identifying and aggregating exposure to risk on a company-wide basis involves compiling a global risk “book” (similar to those used by financial and other trading institutions) to see the big picture—the different elements of risk—on a consistent basis.


Many risk managers underestimate the true cost of hedging, typically focusing only on the direct transactional costs, such as bid–ask spreads and broker fees. These components are often only a small portion of total hedge costs (Exhibit 1), leaving out indirect ones, which can be the largest portion of the total. As a result, the cost of many hedging programs far exceeds their benefit.

Direct costs account for only a fraction of the total cost of hedging.

Indirect Costs

Two kinds of indirect costs are worth discussing: the opportunity cost of holding margin capital and lost upside. First, when a company enters into some financial-hedging arrangements, it often must hold additional capital on its balance sheet against potential future obligations. This requirement ties up significant capital that might have been better applied to other projects, creating an opportunity cost that managers often overlook. A natural-gas producer that hedges its entire annual production output, valued at $3 billion in sales, for example, would be required to hold or post capital of around $1 billion, since gas prices can fluctuate up to 30 to 35 percent in a given year. At a 6 percent interest rate, the cost of holding or posting margin capital translates to $60 million per year.

Another indirect cost is lost upside. When the probability that prices will move favorably (rise, for example) is higher than the probability that they’ll move unfavorably (fall, for example), hedging to lock in current prices can cost more in forgone upside than the value of the downside protection. This cost depends on an organization’s view of commodity price floors and ceilings. A large independent natural-gas producer, for example, was evaluating a hedge for its production during the coming two years. The price of natural gas in the futures markets was $5.50 per million British thermal units (BTUs). The company’s fundamental perspective was that gas prices in the next two years would stay within a range of $5.00 to $8.00 per million BTUs. By hedging production at $5.50 per million BTUs, the company protected itself from only a $0.50 decline in prices and gave up a potential upside of $2.50 if prices rose to $8.00.

Hedge only what matters

Companies should hedge only exposures that pose a material risk to their financial health or threaten their strategic plans. Yet too often we find that companies (under pressure from the capital markets) or individual business units (under pressure from management to provide earnings certainty) adopt hedging programs that create little or no value for shareholders. An integrated aluminum company, for example, hedged its exposure to crude oil and natural gas for years, even though they had a very limited impact on its overall margins. Yet it did not hedge its exposure to aluminum, which drove more than 75 percent of margin volatility. Large conglomerates are particularly susceptible to this problem when individual business units hedge to protect their performance against risks that are immaterial at a portfolio level. Hedging these smaller exposures affects a company’s risk profile only marginally—and isn’t worth the management time and focus they require.

To determine whether exposure to a given risk is material, it is important to understand whether a company’s cash flows are adequate for its cash needs. Most managers base their assessments of cash flows on scenarios without considering how likely those scenarios are. This approach would help managers evaluate a company’s financial resilience if those scenarios came to pass, but it doesn’t determine how material certain risks are to the financial health of the company or how susceptible it is to financial distress. That assessment would require managers to develop a profile of probable cash flows—a profile that reflects a company-wide calculation of risk exposures and sources of cash. Managers should then compare the company’s cash needs (starting with the least discretionary and moving to the most discretionary) with the cash flow profile to quantify the likelihood of a cash shortfall. They should also be sure to conduct this analysis at the portfolio level to account for the diversification of risks across different business lines.

Companies should develop a profile of probable cash flows—a profile that reflects a company-wide calculation of risk exposures and sources of cash.

A high probability of a cash shortfall given nondiscretionary cash requirements, such as debt obligations or maintenance capital expenditures, indicates a high risk of financial distress. Companies in this position should take aggressive steps, including hedging, to mitigate risk. If, on the other hand, a company finds that it can finance its strategic plans with a high degree of certainty even without hedging, it should avoid (or unwind) an expensive hedging program.

Look beyond financial hedges

An effective risk-management program often includes a combination of financial hedges and nonfinancial levers to alleviate risk. Yet few companies fully explore alternatives to financial hedging, which include commercial or operational tactics that can reduce risks more effectively and inexpensively. Among them: contracting decisions that pass risk through to a counterparty; strategic moves, such as vertical integration; and operational changes, such as revising product specifications, shutting down manufacturing facilities when input costs peak, or holding additional cash reserves. Companies should test the effectiveness of different risk mitigation strategies by quantitatively comparing the total cost of each approach with the benefits.

The complexity of day-to-day hedging in commodities can easily overwhelm its logic and value. To avoid such problems, a broad strategic perspective and a commonsense analysis are often good places to start.

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Dynamic Hedging

Corporate FX challenges

The effort vastly improved the company’s planning and execution functions, they knew that in order to succeed in this era of technology their accounting systems needed to be much more robust than what they are. They turned to Today Markets consulting to improve their accounting systems.

When it comes to currency management, most businesses experience similar pain points:

  FX volatility, causing a negative impact on the business
· Lack of visibility over FX exposure and unreliable forecasting
· Flawed manual processes to identify and capture FX exposure
· Inefficient treasury or financial risk management systems
· Immature or informal hedging practices
· Inability to analyse exposures and measure hedging results.

Micro-hedge your foreign currency transactions

Dynamic Hedging is the fully automated solution that eliminates FX risk and makes it easier to buy and sell in local currencies. With profit margins safeguarded, your business is more competitive and primed to increase market share.

Companies with manual hedging processes are more vulnerable to FX risk. Micro-hedging addresses this shortcoming by hedging each transaction (e.g. a receivable or payable), as it occurs.

Using straight-through processing (STP) to speed up processing time, Dynamic Hedging streamlines the workload, no matter how many transactions are being processed, or how small the amount. Currently, larger Currency Hedger clients hedge more than 20,000 micro-transactions a year while others manage their risk in 115 currency pairs.

Boost Efficiency

Automate processes to boost efficiency

Standardize your FX management procedures

Automate micro-trade executions according to market movements

Save time and reduce human error by eliminating manual processes

Liberate your finance team from low-value administrative tasks.

Secure Margins

Take full control of your FX exposure

Capture FX exposure data in real-time

Hedge risk safely and efficiently in all your currency pairs

Monitor currency volatility 24/6

Hedge micro-transactions based on your company needs.

Secure margins and protect your b- line

Effortlessly add new currency pairs when expanding into new international markets

Retain and drive profits with safeguarded margins

Minimise FX gains and losses

Reduce P&L volatility with our Hedge Accounting solution.

Streamline reporting with CH

Use built-in analytics to streamline reporting for your CEO and the board

Oversee your FX exposure with our data-rich analytics dashboard

Gain a better visual representation of when settlements will occur to improve cash management.