Contango vs. Backwardation: What is the Difference?
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Summary:
Contango and backwardation both describe the slope of a forward-facing futures curve in the futures market. When a market is in contango, the forward price of a futures contract sits above the spot price. Conversely, when in a backwardation market, the forward price of a futures contract sits below the spot price.
When it comes to futures trading, knowing how to read and predict patterns on a chart is an important component of success. Two of these patterns, contango and backwardation, can help discern whether the price of futures contracts may rise or fall over time.
Knowing how to spot contango vs. backwardation on a chart can help traders identify the pattern of futures market prices over time. (Specifically, if they’re set to rise or fall.) In turn, this allows traders to make trades that may potentially profit from these price discrepancies. However, it’s easy to confuse these curves, which makes learning the difference even more crucial to avoid serious losses in the futures market.
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Breaking down the basics of futures markets
Commodity traders often use industry-specific lingo in their day-to-day. While said lingo benefits busy traders in a hurry, for outsiders, it gets confusing – fast. Since we rely on this jargon to explain contango and backwardation, let’s take a 101 investment banking crash course on crucial terms.
Commodities
Commodities are physical items that trade in various markets and may be “upcycled” into bigger, more expensive items. Examples include rubber, gold and other precious metals, oil and gas, sugar, and beef.
Futures contracts
In finance, “futures” are contracts between at least two parties to complete an action at a specified future date and price. One party (the buyer) agrees to purchase an asset, while the other party (the seller) agrees to sell the physical asset. Both parties agree to a set price and future delivery date for the asset to be paid for and delivered.
Futures contracts help keep physical commodities markets stable and ensure steady supply and demand in essential (but often unpredictable) markets. For instance, mining companies, farmers, and oil and gas firms may enter a futures contract to confirm their products have guaranteed buyers.
But producers and purchasers in the commodity markets aren’t the only market participants who use these contracts. Traders and investors can buy, short, or otherwise hedge futures without intending to purchase the actual products to (hopefully) profit off of the price discrepancies. This occurs in the futures market.
Pro Tip
As an investor, futures are considered derivatives because they “derive” value from the underlying commodity. Some investors use these to boost portfolio returns compared to investing in the SPX or SPY. That said, derivative products are risky and only advised for advanced investors. If you’re determined to start in the futures market, consider speaking to a financial advisor before you do so.
Futures price and spot price
Lastly, we have the futures price and the spot price. The futures price is the price at which two parties in a contract agree to buy or sell a commodity. By contrast, the spot price is the current market or delivery price. In other words, it’s what you’d pay to have the same commodity delivered at this moment.
Pro Tip
It’s not uncommon for the futures price and spot price to vary. However, if the futures price and spot price don’t meet when a contract reaches maturity, one party might get a better deal.
What does a normal futures curve look like?
Before we explore the key differences between normal contango and normal backwardation curves, let’s start with a normal vs. inverted futures curve. In the chart below, we can plot futures prices (the y-axis) against contract maturity dates (the x-axis).
This example highlights how contract futures prices may change as their maturities extend in normal versus inverted markets. In a normal futures curve, futures prices tend to rise for longer contract maturities. But with an inverted curve, futures prices decline at longer maturities.
In the chart above, the spot market price stands at $50. In a normal market, a one-year futures contract is priced above the spot price (in this example it is priced at $110). As such, if you take a long position in a one-year contract, you are required to purchase one contract for $110 in one year.
By contrast, in the inverted market, the futures price for one-year deliveries ($25) falls below the spot price ($50). Therefore, if you take the long position in a one-year contract, you’re betting that the futures price will fall below the current price.
Contango vs. backwardation
With the basics out of the way, we can now look at contango and backwardation trends. The difference is in which direction the line on a chart slopes when comparing spot and futures prices. Because the future price and expected spot price both change, it’s possible for these curves to switch as contracts approach maturity.
Understanding contango
Contango occurs when the current futures price is above the expected future spot price. In other words, futures with distant maturities trade at a premium to the spot price.
Typically, we expect the future price and spot price to converge, or meet when contracts mature. In a contango market, we expect the futures price to fall over time to meet the expected future spot price.
A futures contract in contango will gradually fall over time as the contract approaches its maturity date. As such, traders with short positions generally find contango favorable.
Contango markets may occur due to factors like storage costs, financing, or insurance. Inflation and expectations of future price hikes can also contribute to contango trends. Often, you’ll find long-term contango trends in industries where (nonperishable) products like gold must be stored.
Understanding normal backwardation
Backwardation, sometimes called normal backwardation, occurs when the current futures price sits below the current spot price. In other words, futures with distant maturities trade at a discount to the spot price.
Because we expect the forward contract and spot prices to converge when contracts mature, contracts in backwardation may rise over time, producing an upward sloping futures curve. As such, backwardation trends generally favor traders who take net long positions.
Backwardation markets can occur when there’s a benefit to physically owning a material, such as keeping a production process running. But it can happen for other reasons, too, such as short-term market conditions that cause the current spot price to rise. (For example, a mine collapse could increase copper prices, spiking the spot price over the forward price.)
However, backwardation seldom arises in commodities like gold and silver. You’re more likely to see backwardation in perishable or usable goods such as groceries, oil, or natural gas.
Example of contango vs. backwardation curves
Now, let’s look at a visual example of backwardation and contango curves compared to spot prices. This graph may look contradictory at first when you compare them with previous examples because it shows the change over time of futures prices based on the expected behavior of investors instead of the spot price vs the futures price. So, for example, if a commodity’s future is significantly cheaper than the current price (i.e. backwardation), investors are expected to buy futures, bringing its price up.
In this example, assume that you purchase a futures contract with a spot price of $50.
If today’s cost for a one-year futures contract sits at $110, the expected price remains above the expected future spot price. This leads to a contango market, where the forward price should fall over time. Conversely, the future expected spot price may rise over time.
By contrast, if today’s cost for a one-year futures contract is $10, the futures price sits below the expected future spot price. This leads to a backwardation market, where the forward price should rise over time. However, the expected spot price could fall over time to produce the same result.
Pro Tip
If forward contract and spot prices don’t converge, an arbitrage opportunity may arise for investors who trade alternative investments. During arbitrage, a trader may buy and sell the same asset in two markets to profit from price differences.
Why do backwardation and contango matter?
On its face, it seems like contango and backwardation primarily matter to investors seeking to profit from future price discrepancies.
However, that’s not true. Contango and backwardation trends can inform a lot more than investment markets. They also inform supply and demand – especially in commodities such as mined metals, crude oil, and agriculture.
Normal backwardation in the beef market
For instance, a short- or long-term supply shortage in the cattle market could lead to a backwardation trend. Because the price of beef goes up now, the current spot price could rise above its futures price. These higher prices could constrain supply and demand while also encouraging beef farmers to increase production.
As a result, more beef could enter the market as farmers try to take advantage of higher prices. At the same time, consumers may switch from beef to pork to save money, leading to a spike in pork demand (and prices).
Contango in the crude market
Now, let’s imagine that the crude oil market experiences a sudden surplus when a big company digs a new well. While crude oil is in high supply now, that doesn’t mean these supplies will remain abundant.
If producers believe that this high supply hurts their profit margins, other oil companies might reduce their production. In turn, this could decrease the surplus and cause the future price to rise again as demand outpaces supply.
On the other hand, decreasing public supply might mean that producers shell out a higher storage cost to safeguard their reserves. That may also increase financing and insurance costs, which will eventually cause higher future prices, anyway.
FAQs
Which is better: contango or backwardation?
That depends on your position as a trader. Investors with short positions tend to benefit from contango markets as prices fall. Meanwhile, investors with long positions tend to benefit from backwardation markets when the future price rises.
Is contango bullish or bearish?
Contango is considered a bullish sign because the market expects the price of the underlying commodity to rise.
Is oil usually in contango or backwardation?
Oil is often in a backwardation curve because short-term supply fears often drive up the spot month price. By contrast, precious metals are less likely to suffer backwardation, as supply is less subject to interruption compared to the energy commodity market.
How do you make money on contango?
There are two main strategies an investor can use to make money on a futures market in contango: arbitrage or buying and holding the underlying.
In the arbitrage strategy, an investor can buy the commodity at the lower spot price and immediately sell it at the higher futures price. This arbitrage strategy causes the spot and futures prices to converge as the expiration approaches and reduces contango.
The buy-and-hold strategy can be used if the investor feels that the contango condition is a signal that the price of the underlying commodity will rise in the future. In this strategy, an investor will buy the commodity with hopes to profit from the rise in spot prices. This strategy only works if the price of the underlying increases.
Key Takeaways
- Futures markets are considered normal if futures prices are higher at longer maturities.
- Futures markets are considered inverted if futures prices are lower at longer maturities.
- Contango occurs when the futures price rises above the current and/or expected future spot price. As a result, futures prices must fall to meet the expected future spot price. Contango markets are often confused with a normal futures curve.
- Normal backwardation occurs when the futures price falls below the current and/or expected future spot price. As a result, futures prices must rise to meet the expected future spot price. Backwardation markets are often confused with an inverted futures curve.
- Contango and backwardation trends can help shape both production and investment markets by forecasting supply, demand, and future pricing.
- Most investors will find it’s safer, easier, and less stressful to invest in the stock market compared to derivatives markets.
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