Hit the Spot: Understanding Contango and Backwardation in Futures Investing

Hit the Spot: Understanding Contango and Backwardation in Futures Investing

Commodities futures contracts are just as lucrative as they are risky. Here are the techniques pro futures traders use.

Hit the Spot: Understanding Contango and Backwardation in Futures Investing
Guy Ovadia

ByGuy Ovadia

Updated Jul 20, 2022

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Anyone looking into the best futures trading strategies will likely be introduced to the words backwardation and contango. Even the best investment commodities can be risky if you're investing in futures, so comparing contango vs backwardation and understanding the difference between them could help you navigate the risks of commodity futures investing.

Backwardation vs contango

Contango and backwardation define the direction of the forward price curve of commodity futures contracts. In simpler terms, these are used to describe when a futures market projection expects the future price of the commodity to be higher or lower than the spot price. When the price of commodity futures contracts is trending upward, then the market is in contango, and when the price of futures is trending downward, then the market is backwardated.

Normal backwardation indicates that a futures price will likely go up to close the gap with the spot price, while a futures price in normal contango will most likely decrease over time to meet with the spot price.

There is an important distinction between backwardation and contango in theory and actually observing them on the market. Both contango and backwardation theories posit that the spot price will eventually converge with the delivery price that the futures market expects. This means that, over time, the spot price of a futures contract should theoretically move closer to the expected spot price at the time of delivery.

Forward curve

The crucial concept driving both contango and backwardation in commodity futures markets is the forward curve or futures curve. The forward curve is a graph that determines the price of contracts as a function of their time to maturity. Forward curves are not a price forecast but are rather snapshots that tell you if a futures contract is being traded at a premium or at a discount compared to its expected future spot price at delivery.

What is contango?

A normal futures curve is when the futures price curve is trending upwards, meaning the future prices market for that commodity is in contango. This shows that the price of a forward contract is higher the further away its maturity date is, thus traders are paying a premium for long-dated contracts compared to the expected spot price. Assuming the market is efficient would entail that the premium baked into the current futures price equals the overhead cost of storing the commodity until the contract matures and delivering it.

However, it would be presumptuous to believe that markets are efficient, so that's where contango theory comes in. In contango theory, the price of a futures contract will decrease and eventually converge with the commodity's spot price as the contract gets closer to the delivery date. This implies that a normal forward curve indicates that the premium on the forward price will shrink as a futures contract nears maturity.

What is backwardation?

A futures market is said to be backwardated when there is an inverted futures curve, or the futures price curve is trending downward. This is essentially the opposite of contango, so the spot price of a futures contract is lower the further its maturity date is. This shows that futures traders are paying a negative premium on long-dated contracts, so they would theoretically be getting a discount on commodity futures.

Normal backwardation theory states that the futures price will increase over time as the contract approaches maturity. In other words, the price of a futures contract in a backwardated market will go up as it matures so as to converge with the expected spot price of the underlying commodity. Observing normal backwardation on a forward curve would mean that futures prices are low compared to the expected spot price at the time of delivery.

You don't question magic.

You don't question magic.

Market-based theories: yay or nay?

Problems with backwardation and contango

The main issue with normal backwardation and contango theories is that they're an extrapolation of the futures curve. The futures curve is an accurate representation of futures prices as a function of the date the physical asset will be delivered based on one day's market activity, but they aren't a projection of what the forward price or spot price of a commodity will be.

A futures curve can tell us, for instance, whether crude oil futures are in a contango market or in backwardation, but it can't tell us for certain what the crude oil futures price will be or what the expected crude oil spot price is. In fact, the expected spot price is a purely theoretical figure that can't actually be determined. Put differently, expected spot prices are just an idea and don't actually represent the current or future spot price of a commodity.

So, even if it were true that the futures price always eventually converges with the expected spot price, we have no way of knowing where that convergence will actually occur. What the model does convey are the overall price trends of backwardation contango—normal backwardation indicates that a futures price will likely go up to close the gap with the spot price, while a futures price in normal contango will most likely decrease over time to meet with the spot price. 

How to buy a futures contract 

Having an understanding of contango vs backwardation is extremely useful for constructing mental models of how commodity futures prices could perform in a normal market. However, contango and backwardation are just one tool in the futures trader toolbox, so you'll need a futures trading platform with all the analysis and informational resources you'll need to succeed in commodities markets. That's why you should sign up for TradeStation.

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TradeStation is a trading platform that lets you buy and sell stocks, ETFs, IPOs, crypto, and, of course, futures and options. TradeStation offers commission-free trading and accessible subscription plans for retail investor accounts so they can be your one-stop shop for investing. Whether you're actively trading futures or looking for a place to invest your cash, TradeStation is the platform to be on. 

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