Hi QC Community

Contango in Futures occurs when the spot prices of further-term contracts are higher than that of nearer-term contracts, adjusted for inflation. It can be considered the Futures yield curve. Contango happens due to rising costs in holding the physical asset, such as storage, insurance, and financing costs. When investors believe these costs are increasing, the demand of using a forward contract to secure the trading price increases.

In this strategy, we try to make a profit from predicting the development of this horizontal spread and monetary inflation. We set our universe to be all gold Futures contracts expiring within 90 days to avoid tying up our fund for too long. Since contango is most likely to happen when the future cost is higher, we set up an SMA of ROC indicator to predict short-term return mean-reversion. When the last return is lower than the trailing mean return, we measure the horizontal spread between each pair of contracts in the universe. We select the pair of contracts that has the lowest horizontal spread, then buy the contract in the pair with the furthest expiry and sell the contract in the pair with the nearest expiry in order to maximize the possibility of mean-reversion.

The strategy successfully yielded a positive return with a 1.28 Sharpe Ratio, but it is likely not translatable into all-weather usage since it has no mechanism to neutralize systematic risk and solely relies on microeconomics. It's recommended to use with a market regime identifier.

The current implementation doesn't evaluate the potential contango chance and size. To improve the strategy, we could set up a calculator for that and an early exit handler to free up invested capital for more opportunities. We might also refine the indicator for future price/contango prediction. One more suggestion would be to construct an efficient portfolio by treating the price difference between a pair of contracts as a single series to obtain a covariance matrix for all pairs. We can thus include more assets and contracts to scale up the investment.

Best
Louis

Author