Contango vs Backwardation in Futures Trading (2024)

FAQs

Contango vs Backwardation in Futures Trading? ›

Contango and backwardation are terms used to define the structure of the forward curve

Contango is a futures market occurrence marked by futures contract prices rising above spot prices. It means that traders and investors anticipate an increase in prices in the coming months. The opposite of contango is backwardation, when futures prices are lower than spot prices.

Contango is typically a condition of a bullish market, where people think prices and demand will go up in the future. Backwardation is a condition of a bearish market, where investors think prices and demand will fall in the future. Contango is more common.

A trader would short the spot month contract and buy the further out month. This trade would profit if the market increases its contango structure. The trade would lose money if the market reverts to a normal backwardation structure. In backwardation, the spot price is higher than the price for farther-out contracts.

The primary cause of backwardation in the commodities' futures market is a shortage of the commodity in the spot market. Manipulation of supply is common in the crude oil market. For example, some countries attempt to keep oil prices at high levels to boost their revenues.

Backwardation for Investors

If you think the price of a commodity will fall in the future as predicted by the backwardation curve, one way to make money is by short selling near-term futures contracts which you then offset by buying another futures contract for a later date.

In a normal market, longer-dated futures contracts are priced higher than current spot prices, due to inflation and the risk of other unknown market factors that may develop over time. Markets may also trade in contango because the asset or commodity in question has associated carrying costs, or storage costs.

Hedging is attractive because gold is almost always in contango, which means the futures and forward prices are almost always higher than the spot price. The forward curve rises as a function of interest rates. The chart shows gold mining industry hedging activity since 1982.

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.

Contango is when the futures price is above the expected future spot price. A contango market is often confused with a normal futures curve. Normal backwardation is when the futures price is below the expected future spot price. A normal backwardation market is often confused with an inverted futures curve.

What would cause a futures market to move from contango to backwardation? ›

Backwardation happens when nearby, or spot, futures prices are higher than the further-expiration contracts, producing a downward-sloping forward curve. Short-term supply disruptions may send a market into backwardation as traders bid up nearby prices of, say, oil in anticipation of tighter inventories.

Some markets can spend a great deal of time in backwardation while others spend the majority of their time in a state of contango. In addition, certain markets may be more vulnerable to going into a state of backwardation due to potential issues associated with that market.

Backwardation is a market condition in which a futures contract that is far from its delivery date trades at a lower price than a contract closer to its delivery date. So, in other words, the spot price—also known as the market price—for the underlying asset is higher than the futures contract.

Generally speaking, a normal situation for durable and easily storable commodities which have a cost of carry, such as gold, is contango.

A steeply contango forward curve for a commodity means that the supply-demand balance of the commodity is very bearish in the near term but will eventually become bullish in the long term.

What happens during backwardation? In backwardation, the futures price is lower than the expected spot price of the underlying asset at the contract's expiration. That means the futures contract trades at a discount to the spot price.

Suppose we entered into a December 2023 futures contract today for $100. Now go forward for one month. The same December 2023 futures contract could still be $100, but it also might have increased to $110 (this implies normal backwardation) or it might have decreased to $90 (implies contango).