In this post, I will explain contango versus backwardation with straightforward examples and charts. Additionally, I’ll demonstrate how understanding these concepts can enhance your profitability when trading futures.
The futures market for a given commodity can either be in contango (normal market) or backwardation (inverted market), depending on the price relationships between contracts of different delivery months.
Contango – the normal futures market
A normal futures market occurs when the price of the nearby futures contract is lower than the price of the deferred (distant) futures contract. In other words, distant months are priced higher than nearby months.
This type of market indicates an adequate supply of the commodity. A normal market reflects a discount basis, meaning cash prices are lower than futures prices.
This kind of market reflects an adequate supply of the commodity. A normal market reflects a discount basis, because cash prices are lower than the futures prices.
It is also referred to as a carrying charge (storage) market or futures price in contango because the price difference between contracts for various delivery months reflects the carrying charges. Carrying charges cover the costs associated with holding or storing inventory of the commodity.
In efficient markets, commodity futures contracts are priced to include the cash price plus the carrying charge. This means that the price difference between futures contracts of different delivery months in a normal market should account for the carrying charges. When futures contract prices equal or exceed the cash price plus the full carrying charges, it is known as a carrying charge market or contango market.
Arbitrage
Additionally, when the difference between cash and futures prices exceeds the carrying charges, arbitrage opportunities arise. An arbitrageur can profit by buying the nearby contract and simultaneously selling a distant contract when the price difference exceeds the carrying charges. As prices revert to their normal relationship, the arbitrageur gains from this temporary price discrepancy. Arbitrage exploits these temporary abnormal price differences and, when executed correctly, is relatively low-risk.
Arbitrage in Contango Market. Example
Assume that the carrying costs for silver (storage, interest, and insurance costs) are $.05 per month. The silver market reflects the following prices:
By buying May futures and selling July futures, the arbitrageur will profit by $.02 per ounce. The $.10 cost of storing silver for two months added to the purchase price of $7.04 totals $7.14. Because the sale price was $7.16, the profit is $.02 per ounce.
An arbitrageur takes advantage of small discrepancies in price between cash and futures markets. While many traders view arbitrage as risk-free, transaction costs associated with trading can reduce or even eliminate any potential profits.
Backwardation – the inverted futures market
In a backwardation or inverted market, the price of the cash market or the nearby futures contract is higher than the price of the deferred (distant) futures contract. This inverted relationship indicates a premium basis, meaning cash prices are higher than futures prices.
Inverted markets occur when the supplies are not adequate, and they translate to relatively high cash market prices.
Backwardation is always caused by short supply – not increased demand!
Key points
Contango (Normal Futures Market): Prices for distant futures contracts are higher than for nearby futures contracts. This market is also known as a carrying charge market or contango market.
Backwardation (Inverted Futures Market): Prices for distant futures contracts are lower than for nearby futures contracts. This is also known as a backwardation market and may occur when there is a current shortage of the commodity. Note that for interest rate futures markets, backwardation occurs when distant contracts are at a premium to near-month contracts.
Normal Market: In a normal market, carrying charges constrain the price differences between nearby and distant futures contracts.
An alternative way to visualize the differences between contango and backwardation appears in the graphic.
Contango vs backwardation. How to profit from this knowledge?
As discussed, backwardation or an inverted market occurs when a nearby contract trades at a premium. But why does this happen, and how can you profit from it?
A premium indicates that someone is willing to pay a higher price to obtain the commodity immediately, rather than waiting for a future delivery. This often happens because the buyer needs the commodity for current production or use. Essentially, an inverted market is driven by actual producers and users, not speculators.
In many cases, a premium leads to a parabolic rise in commodity prices, which can be a key indicator for spotting major trends. However, it’s important to note that this is just one of several factors used to identify significant market movements.
Wishing you a great week!
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