Backwardation and contango: opposite situations in the futures markets

Futures markets constantly demonstrate interesting patterns in pricing. One of the key phenomena is the relationship between the current price of an asset and its value in futures contracts. Such interconnections are indicated by the terms contango and backwardation, which help traders and analysts understand market sentiment and find trading opportunities.

When futures prices fall below spot prices: backwardation

Backwardation occurs when a futures contract is trading cheaper than the current market price of the underlying asset. Imagine: Bitcoin is currently worth $50 000, but three-month futures contracts are trading for only $45 000. This is backwardation — a discount to today's price.

Why do market participants agree to such terms? This usually happens in the context of pessimistic expectations. Traders fear negative news, changes in regulations, or other factors that could lead to a decline in value.

The supply deficit is another reason for backwardation. When there is a shortage of goods (, whether it is a physical asset or a financial instrument ), current demand increases. As a result, those who need immediate access to the asset are willing to pay a premium for the spot contract, while deferred futures purchases become less attractive.

As the expiration date approaches, futures contracts may fall in price even lower. Traders who have opened short positions are forced to close them to avoid the obligation of physical delivery. This mechanism strengthens backwardation.

When futures prices rise above spot prices: contango

The opposite picture is seen in contango. Here, the futures contract is priced higher than the current market price. If Bitcoin is quoted at $50 000, and three-month futures are trading at $55 000 — this is a classic example of contango.

Such a premium reflects market optimism. Participants expect the asset price to rise in the foreseeable future. Additionally, contango may be due to storage costs, financial expenses related to holding the asset, or interest rates that affect borrowing costs. For commodities like oil or agricultural products, transportation and storage require significant expenses, which are directly factored into the price of futures contracts.

In periods of bullish trends, contango intensifies, especially when positive news is released or the interest of institutional investors grows.

Trading Applications: How Traders Use Contango and Backwardation

Understanding these phenomena opens the door to arbitrage strategies. In contango, experienced participants can buy the underlying asset at a low spot price and simultaneously sell a futures contract at a higher price, locking in profits from the difference.

In a backwardation scenario, the logic is different. Traders can open short positions on futures, betting on further declines in the asset's price.

For producers and consumers (, such as companies working with oil or grain ), contango and backwardation serve as hedging tools. By buying or selling futures contracts, they lock in future prices and protect themselves from unfavorable market movements.

Contango provides the opportunity to open long positions in anticipation of a rise in the price of the underlying asset, while backwardation can be used for positions on a decline. Both market conditions contain opportunities for both speculators and conservative investors seeking to protect their portfolios.