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Backwardation and contango are terms used in the context of futures markets to describe the relationship between the prices of futures contracts with different expiration dates for a specific underlying asset, such as commodities, currencies, or financial instruments. In this article, we aim to explain these terms within the context of futures contracts.
Futures Contracts Revised
Let’s start with a brief overview of futures contracts. A futures contract is an agreement to buy or sell an asset at a predetermined price at a specified time in the future. These contracts are traded on organized futures exchanges and can relate to a wide variety of underlying assets, including commodities, currencies, stock indices, interest rates, and more.
Futures contracts can be settled in two ways: either through physical delivery, where the underlying asset is physically delivered on the specified date, or through cash settlement, where the difference between the contract price and the market price on the settlement date is paid in cash.
Each futures contract expires on the third business day prior to the 25th calendar day of the month preceding the delivery month.
There are five key components of a futures contract namely:
Futures contract participants are generally of three types
What are Backwardation and Contango?
Backwardation and contango describe the relationship between the spot price of an asset and the prices of multiple futures contracts for that same underlying asset with different expiration dates. Simply put, these states are determined by more than one price level.
Backwardation
Backwardation occurs when the futures prices for contracts with near-term expiration dates are higher than the prices for contracts with later expiration dates. This situation suggests that the market anticipates a shortage of the underlying asset in the near future.
Reasons for backwardation include:
Contango
Contango refers to a situation in which the futures prices for contracts with later expiration dates are higher than the prices for contracts with nearer expiration dates. Contango suggests that the market expects the supply and demand dynamics of the underlying asset to be more balanced in the near term and potentially oversupplied in the future.
Reasons for contango include:
The Futures Curve
Backwardation and contango are often illustrated through the use of a futures curve, which shows how the prices of futures contracts change over different time horizons.
This curve begins with the current spot price and includes the prices of futures contracts with various expiration dates. By connecting these points, the curve’s shape—whether in backwardation or contango—reveals market expectations about future supply and demand, the cost of carry, interest rates, and other factors.
Oil futures Example
The following table below shows a snapshot of oil futures prices from August 2023.
Expiry Month | Futures Prices by Expiry Month |
Sep-23 | 81.4 |
Oct-23 | 80.73 |
Nov-23 | 80.22 |
Dec-23 | 79.81 |
Jan-24 | 79.32 |
Feb-24 | 78.92 |
Mar-24 | 78.57 |
Apr-24 | 78.11 |
May-24 | 77.75 |
Jun-24 | 77.39 |
Jul-24 | 76.98 |
Aug-24 | 76.56 |
Sep-24 | 76.19 |
Oct-24 | 75.82 |
Nov-24 | 75.5 |
Dec-24 | 75.17 |
Although this is useful, the picture is far clearer when these prices are plotted on a graph (See below)
As you can see the slope is downwards and so would be described as in backwardation.
Where Can I Get Information on the Curve?
Most major financial exchanges that trade commodity futures, such as CME Group and Intercontinental Exchange (ICE), provide information on current futures curves.
Conclusion
Contango and backwardation are relevant to a wide spectrum of market participants, from speculative traders to long-term investors and from individual investors to companies and institutional entities. Understanding these market conditions is valuable for decision-making, risk management, and identifying potential opportunities.
GO Markets offers a wide range of CFD futures contracts that you can trade on platforms like MT4 and MT5, and we would be delighted to assist you with any questions you may have.
Disclaimer: Articles are from GO Markets analysts and contributors and are based on their independent analysis or personal experiences. Views, opinions or trading styles expressed are their own, and should not be taken as either representative of or shared by GO Markets. Advice, if any, is of a ‘general’ nature and not based on your personal objectives, financial situation or needs. Consider how appropriate the advice, if any, is to your objectives, financial situation and needs, before acting on the advice. If the advice relates to acquiring a particular financial product, you should obtain and consider the Product Disclosure Statement (PDS) and Financial Services Guide (FSG) for that product before making any decisions.
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