Contango and backwardation are two ways to characterize and understand the state of the commodities or cryptocurrency futures markets, based on the relationship between spot and future prices.
In short, contango is a market in which futures trade at spot prices that are higher than the expected future spot price. But a contango market is not the same thing as a normal futures curve, though it is often mistaken for one. Normal backwardation, on the other hand, is a market where futures trade at a price that’s lower than the expected future spot price.
Futures and Derivatives
It’s important to have an understanding of both futures and derivatives to fully understand the difference between contango and backwardation.
Futures, Explained
Futures contracts, or futures, consist of legal agreements to buy or sell a security, commodity or asset at a set time in the future, for a predetermined price. One feature for both buyers and sellers of futures is that they can execute the contract no matter what current market price of the underlying asset when the contract expires.
Companies use futures contracts to hedge their risk of massive shifts in commodities prices, and investors who believe that the underlying security will go up or go down by a certain amount of time over a fixed period of time. The buyer of a futures contract enters a legal agreement to buy the underlying asset at the contract’s expiration date. The seller, on the other hand, agrees to deliver the underlying security at the agreed-upon price, when the contract expires.
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Derivatives, Explained
A derivative refers to any financial security whose value rises and falls based on the value of another underlying asset, such as a security or commodity. That includes securities such as futures, options, and swaps. The most common assets upon which derivatives are based include securities like stocks and bonds, commodities like oil or other raw materials, but they may also reflect currencies and interest rates.
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The Futures Curve
When writing futures contracts for a given asset, the futures seller will place different prices on that commodity at different points in the future. While the base price of a futures contract is determined by adding the cost of carrying the underlying asset to its spot price, it also includes an element of prediction. People buy more oil in the winter to buy their homes, for example, so oil investors may predict that oil will be in higher demand — and thus cost more — in January than it will in May.
By comparing the prices within futures contracts for the same underlying asset at different points in the future, the dollar amounts form a curve.
Normal Futures Curve vs Inverted Futures Curve
In a normal futures curve, the prices assigned to the underlying asset of futures contracts goes up over time. In the example of oil, a normal futures curve will be one in which a barrel of oil is priced at $50 for a contract expiring in 30 days; $55 for a contract expiring in 60 days; $60 for a contract expiring in 90 days, and $65 for a contract expiring in 120 days.
A normal futures curve embodies an expectation that the price of the asset underlying the futures contracts — such as oil, soybeans, a stock, or a bond — will rise over time. An inverted futures curve assumes just the opposite.
To go back to the example of oil, in an inverted futures curve, a barrel of oil is priced at $50 for a contract expiring in 30 days; $45 for a contract expiring in 60 days; $40 for a contract expiring in 90 days, and $35 for a contract expiring in 120 days.
The futures curve is used by investors, policymakers and corporate treasurers as an indicator of popular sentiment toward the underlying asset. And the prices of those futures contracts can represent the market’s combined best guess about the prices of those assets.
The spot price of the asset, on the other hand, the price at which it’s currently trading. It’s the relationship between the spot price and the prices on the futures curve that determine if the futures market is in a state of backwardation or contango.
What Is Backwardation?
When an asset is trading at spot prices that are higher than the prices of that asset as reflected in the futures contracts maturing in the coming months, it’s called backwardation.
It can happen for a number of reasons, but most commonly occurs because of an unexpectedly higher demand for the underlying asset, especially in cases of a shortage in the spot market. Sometimes backwardation is caused by a manipulation of a commodity’s supply by a country or organization. Decisions by the Organization of Petroleum Exporting Countries (OPEC), for example, could create oil backwardation.
When backwardation occurs in futures markets, traders may try to make a profit by short-selling the underlying asset, while buying futures contracts that promise delivery at the lower prices. That trading drives the spot price down, until it matches the futures price.
What Is Contango?
Contango, on the other hand, is a situation where the spot price of an asset is lower than those offered in the futures contracts. In an oil contango market, for example, the spot price of the oil would rise to match that of the futures contracts at expiration. In contango, often associated with a normal futures curve, investors agree to pay more for a commodity in the future.
Backwardation vs Contango for Investors
Contango and backwardation can occur in any commodities market, including oil, precious metals, or agricultural products. Investors can find different opportunities and investment risks when investing in commodities in both backwardation and contango.
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In backwardation, short-term traders who practice arbitrage can make money by short-selling the underlying assets, while buying futures contracts until the difference between the spot and futures prices disappears.
But investors can also lose money from backwardation in situations where the futures prices keep falling while the expected spot price remains the same. And investors hoping to benefit from backwardation caused by commodity shortage may wind up on the wrong side of their trades if new suppliers appear.
For investors, contango mostly poses a risk for investors who own commodity exchange-traded funds (ETFs) that invest in futures contracts. During periods of contango, investors can, however, avoid those losses by purchasing ETFs that hold the actual commodities themselves, rather than futures contracts.
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The Takeaway
Contango and backwardation are two terms that describe the direction futures markets are headed. Knowing the difference between these two terms can help institutional and retail investors make the strategic choices when investing in a wide range of derivatives markets.
These are fairly high-level terms, and may be used as a part of an advanced trading strategy. If investors don’t feel comfortable investing in derivatives or futures contracts – or similar securities — it may be best to consult with a financial professional to get a better sense of if they fit into your strategy.
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