Contango vs BackwardationDifferences You Need to Know Between the Two!
Contango and normal backwardation are both terms that are used to explain the difference between the spot price and the futures price of a commodity.
These terms are frequently used to describe the futures curve for commodities.
These curves are very different, and yet they are frequently confused with each other.
Backwardation occurs when the spot price of a commodity is higher than the futures price.
Whereas a market is in contango if the futures price is lower than the spot price.
Contango vs. Backwardation
In a contango market, futures prices decline over time, thus approaching the spot prices.
Whereas in backwardation, futures prices increase over a period of time approaching the spot price.
If a contract is in contango, prices tend to decrease.
In contrast, a contract in backwardation will tend to increase in price.
But, in both cases, the prices will converge and be equal on the maturity date of the contract.
When this happens in contracts, it is not necessarily a reflection of the overall price of the commodity.
It may just affect the contract.
Therefore, a forward contract being in contango does not mean the commodity’s price will drop.
It just means the price of the specific contract could drop and converge with the spot price or that the spot price may increase as well.
Both backwardation and contango are market conditions that could change.
The market can change back and forth between these two conditions.
This means when trading, it is best not to depend on the market staying in either of these conditions for any length of time.
Rapid changes between these two market conditions are possible.
Primary Differences
In a normal futures market, the prices will be higher for commodities with longer maturities.
The market is considered inverted when there are lower futures prices in the far future.
When a futures contract is approaching maturity, the futures price will approach the spot price.
The basis is the difference between the spot price and the futures price.
On the date of the contract’s maturity, the spot price and the futures price must be equal.
Otherwise, it would be easy for anyone to make money through arbitrage.
Contango is a situation in which the spot price of a commodity is lower than the futures price.
The futures price will converge with the expected future spot price since contango infers that futures prices will decline over time when additional information is available and causes them to align with the spot prices that are expected in the future.
In normal backwardation, the futures price is lower than the expected spot price in the future.
This is a good situation for speculators who are planning to net long and prefer an increase in futures prices.
Therefore, if futures prices are increasing, this is normal backwardation.
Suppose an individual purchased a futures contract today that matures in one year, and the future spot price is expected to be $80.
Should the one-year contract cost $100 today, then the spot price is below the futures price, which means this is a contango situation.
Then, if the expected future spot price does not change, the price for the contract will have to drop.
In a month’s time, there will be a contract for eleven months, and in five more months, a six-month contract.
Why It Is Important To Understand Backwardation and Contango
Futures markets were first started as a way for merchants selling commodities to sell their products at a future time but at the current price.
However, some buyers of commodities and futures do not intend to actually take possession of the commodity they are trading for.
As an example, a trader could purchase a futures contract for 60 tons of wheat but choose not to take delivery of the wheat.
They may decide, instead, to trade in hopes of obtaining a profit.
This will occur if the closing price is greater than the price they paid for the contract.
If a trader understands both backwardation and contango, it can be useful in making decisions because the trader will know the way in which futures prices and spot prices are related.
This could help traders to avoid losses when trading in the futures or forward markets.
Key Takeaways
- Contango is a situation in which the futures price is higher than the spot price.
- An inverted futures curve is sometimes confused with a backwardation market.
- Backwardation is a situation in which the futures price is lower than the expected spot price.
- In a normal futures market, prices are higher for futures contracts at longer maturities.
- A contango market is frequently mistaken for a normal futures curve.
FundsNet requires Contributors, Writers and Authors to use Primary Sources to source and cite their work. These Sources include White Papers, Government Information & Data, Original Reporting and Interviews from Industry Experts. Reputable Publishers are also sourced and cited where appropriate. Learn more about the standards we follow in producing Accurate, Unbiased and Researched Content in our editorial policy.
University of Illinois "Contango and Backwardation as Predictors of Commodity Price Direction" White paper. April 13, 2022
Edhec Business School "Backwardation and Commodity Futures Performance: Evidence from Evolving Agricultural Markets" White paper. April 13, 2022