Contango and backwardation definition

What are contango and backwardation?

Contango and backwardation are two terms used to describe different conditions in the futures commodity market. They refer to whether the price of a commodity futures contract – known as the futures price – is trading above or below the price quoted for the physical commodity – known as the spot price.

The difference between a commodity’s spot price and its futures price arises because the latter takes a range of variables into account. These include the current spot price, the time until delivery of the futures contract, interest rates on the contract and the cost of carry for the deliverable commodity.

What is contango?

Contango is the market condition in which the price of a commodity futures contract is currently trading higher than the spot price of the underlying.

Contango is the normal market condition for a futures contract. This is because the price for a futures contract accounts for the spot price plus the cost of carry, so it will often be more than just the underlying spot price – depending on the time until delivery.

Contango example

Let’s assume that the spot price of crude oil is £100, but the price of a crude oil futures contract is £110 for delivery in one month. A trader could buy this futures contract on the assumption that the price of oil will rise above £110 before the expiry date arrives.

A market that is currently in contango will experience gradual reductions in the futures price to meet the expected spot price at the delivery date of the contract. However, if the price of the futures contract remains above the spot price in contango, traders could take advantage of the discrepancy in price – this is known as arbitrage.

What is backwardation?

Backwardation is the market condition in which the price of a futures contract is currently trading lower than the spot price of the underlying. It is the opposite to contango and much less common because backwardation tends to affect markets with seasonal changes in supply and demand.

The natural gas futures market is often in backwardation as it sees increasing demand in the winter months and shortages in supply. Traders would take a position in a backwardation market if they expected the price of natural gas to fall, which could happen if supply increased and demand remained at the previous level.

Backwardation example

Let’s assume that the spot price of natural gas is £1000, but the price of a natural gas futures contract is £900 for delivery in one month. A trader could buy this futures contract on the assumption that the price of natural gas will fall below £900 before the expiry date arrives.

A market that is currently in backwardation will experience gradual increases in the futures price to meet the expected spot price at the delivery date of the contract. However, if the price of the futures contract remains below the spot price in backwardation, there could be an arbitrage opportunity similar to a contango market.

How do traders use contango and backwardation?

Traders use contango and backwardation to assess current futures price in relation to the expected spot price of a commodity at delivery. This information can help a trader decide whether to go long or short – depending on whether they believe that the futures price will rise above, fall below or meet the spot price as the delivery date approaches.

Regardless of whether the market is currently experiencing contango or backwardation, the expectation is that the futures price will converge on the spot price as the futures contract approaches its delivery date. If this is not the case, and the futures price remains either above or below the expected spot price at delivery, then an arbitrage opportunity would exist in the underlying market.