Contango and Backwardation

Contango and backwardation are two terms that traders often come across when trading futures contracts. In this article, we will discuss what contango and backwardation are and how traders can incorporate them into their trades.

Understanding Contango and Backwardation

Contango and backwardation are terms used to describe the relationship between the current price of a futures contract and the expected future price of the same contract.

Contango occurs when the current price of a futures contract is lower than the expected future price. This situation usually arises when the cost of holding the physical asset underlying the futures contract, such as storage and financing costs, is higher than the expected return from holding the futures contract.

Backwardation, on the other hand, occurs when the current price of a futures contract is higher than the expected future price. This situation usually arises when the cost of holding the physical asset underlying the futures contract is lower than the expected return from holding the futures contract.

Incorporating Contango and Backwardation into Trades

Traders can incorporate contango and backwardation into their trades by using them to make informed trading decisions. Here are some ways to do so:

1. Trading the Spread: One of the most popular ways to trade contango and backwardation is by trading the spread. This involves simultaneously buying and selling two futures contracts, one in the front month and one in the back month. If the market is in contango, the back month contract will be more expensive, and traders can sell it to take advantage of the difference in price. Conversely, if the market is in backwardation, the front month contract will be more expensive, and traders can buy it to take advantage of the price difference.

2. Roll Over Strategies: Another way to incorporate contango and backwardation into trades is through roll-over strategies. Roll-over strategies involve closing out a current futures contract and simultaneously entering into a new contract with a different expiration date. If the market is in contango, traders can roll over their position by selling the current contract and buying a new contract with a later expiration date. Conversely, if the market is in backwardation, traders can roll over their position by buying the current contract and selling a new contract with a later expiration date.

3. Long-term Positioning: Contango and backwardation can also be used to inform long-term positioning decisions. For instance, if a commodity is in a prolonged period of contango, it may indicate that there is an oversupply of the commodity, and traders may want to take a bearish position. Conversely, if a commodity is in a prolonged period of backwardation, it may indicate that there is a shortage of the commodity, and traders may want to take a bullish position.

Risks and Limitations of Trading Contango and Backwardation

While trading contango and backwardation can be profitable, it also involves risks and limitations. The primary risk is that the expected future price may not materialize, and traders may incur losses. Additionally, trading contango and backwardation requires knowledge and experience in the futures market, and novice traders may find it challenging to incorporate these concepts into their trades.

Conclusion

Contango and backwardation are important concepts that traders should understand when trading futures contracts. By incorporating these concepts into their trades, traders can make informed trading decisions and potentially increase their profitability. However, traders should also be aware of the risks and limitations involved and should only trade contango and backwardation after gaining sufficient knowledge and experience in the futures market.