What is the meaning of Contango and Backwardation in Futures Markets?

The futures markets are closely related to the spot markets. There are a number of futures contracts that are available; ranging from forex futures to metals futures and commodity futures. The futures markets tend to exhibit strong correlation to the underlying spot markets such as FX, Gold and Crude oil.

Therefore, as traders, if you are especially trading the spot markets, it is important to understand what is happening in the futures markets as well. But in order to learn about this, we must first understand what are futures markets and how they work.

What are futures markets?

The futures markets are derivative contracts. This means that the futures prices are derived from the underlying asset’s spot market price. For example, a Euro FX futures contracts derives its price from the underlying asset, which is the euro. The prices for the euro futures contracts are therefore derived from the spot EURUSD market.

This same trend is seen across other markets including gold, crude oil, silver to name a few.

Unlike spot markets, the futures markets are contracts for the future. This means that the buyer of the futures contract can buy the underlying asset for a future delivery. This enables the buyer to hedge against price volatility.

Futures are widely traded and includes a combination of producers, consumers and speculators. A futures contract also has an expiry date. When you are long on a futures contract and hold it to expiry, you will automatically get the delivery of the underlying asset.

For example, a coffee house can engage in a futures contract in the coffee markets by paying the price upfront. Then, holding this contract to expiry will mean that the buyer of the contract will get delivery of the underlying asset, which is coffee, in this example.

Similarly, financial futures such as Euro futures or Australian dollar futures can be used for delivery of the underling currency at a future date.

The futures contracts chain

At any given point in time, there can be atleast four futures contracts that are available for training. Typically, the naming convention is the contract delivery month. Therefore, if you hear about a July futures contract, it means that the contract expires and the underlying asset gets delivered in the month of July.

But as you can guess by now, different contracts trade at different prices, even though they all reflect the same underlying asset. Thus, as a result, the far out month futures contracts can trade higher than or lower than the near month futures contracts.

This discrepancy in price is normal. But this phenomenon can be categorized into two parts, contango and backwardation.

What is contango in futures?

Contango in futures is a phenomenon when the further or far out contracts trade at a higher price than the near month futures contracts. This is also known as forwadation. In other words, contango is the name when the futures prices are higher than the current spot price.

The reason behind this is because there is a cost of carry. In other words, futures traders pay a premium to pay for the commodity for delivery in the future rather than pay for storage costs.

A good example can be seen from the futures markets in oil currently. The chart below shows the forward curve. This is the price of the various futures contracts, expiring at different months.

01 WTI Crude Oil

Example of Contango in Futures – WTI Crude Oil Futures

What is backwardation in the futures market?

Backwardation in the futures markets is exactly the opposite of contango. In backwardation, the price of the immediate futures contracts are much higher than the further out futures contracts.

In backwardation, the cost of buying the near month futures contracts are cheaper comparing to the further out futures contracts. This is favorable for traders who are long on the near month contracts.

An example of backwardation can be seen in the chart below, of the Bitcoin futures contracts.

02 Bitcoin Futures

Example of Backwardation in Futures – Bitcoin futures

What do the terms contango and backwardation infer?

The terms contango and backwardation simply depict the trader sentiment in the futures markets. Generally, contango is the usual norm as it depicts the regular market conditions. It is cheaper to buy an asset now, rather than in the futures.

But given the dynamics of the futures markets, this can change especially when the markets move into a backwardation phase. Depending on the type of futures markets you are looking at, contango and backwardation can signal big changes. This can be true especially in the financial or currency futures and commodity futures markets. At times, contango or backwardation can potentially predict possible changes in the supply and demand and can also predict changes to interest rates or the economy in general.

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