If you trade futures, you have probably heard the terms contango and backwardation. These concepts describe the relationship between futures prices across different expiration dates. Understanding this term structure is essential for rolling contracts, understanding market sentiment, and avoiding unexpected losses.
What is Futures Term Structure?
Futures term structure (also called the futures curve) shows the prices of futures contracts across different expiration dates. When you plot all available contract months on a chart, you can see whether near-term contracts are priced higher or lower than far-term contracts.
Why it matters: The term structure affects your roll costs, signals market expectations, and can create opportunities for spread trades. Ignoring term structure can cost you money over time.
Contango Explained
Contango occurs when futures prices are higher for later delivery dates than for nearer dates. This creates an upward-sloping futures curve where each successive month is more expensive.
What Causes Contango?
- Cost of carry: Storage costs, insurance, and financing make holding the physical commodity expensive
- Normal market conditions: Contango is typical for most commodities in normal times
- Future expectations: Markets expect prices to rise gradually over time
Contango Example: Crude Oil
In a contango market, crude oil prices might look like this:
- Front month (February): $75.00
- March: $75.50
- April: $76.00
- June: $77.00
- December: $79.00
Each successive month is higher, creating an upward-sloping curve.
Impact of Contango on Traders
For long positions, contango creates a negative roll yield. When you roll from a cheaper front-month contract to a more expensive back-month contract, you pay the difference.
Roll Cost in Contango
You are long 1 crude oil contract:
- Sell February at $75.00
- Buy March at $75.50
- Roll cost: $0.50 per barrel = $500 per contract
Over time, repeated rolling in contango erodes your returns.
Backwardation Explained
Backwardation occurs when futures prices are lower for later delivery dates than for nearer dates. This creates a downward-sloping futures curve where each successive month is cheaper.
What Causes Backwardation?
- Immediate demand: Strong current demand pushes near-term prices higher
- Supply disruptions: Shortages today make immediate delivery more valuable
- Hedging pressure: Producers heavily hedge future production, pushing down deferred prices
Backwardation Example: Crude Oil
In a backwardated market, crude oil prices might look like this:
- Front month (February): $80.00
- March: $79.00
- April: $78.50
- June: $77.00
- December: $74.00
Each successive month is lower, creating a downward-sloping curve.
Impact of Backwardation on Traders
For long positions, backwardation creates a positive roll yield. When you roll from a more expensive front-month contract to a cheaper back-month contract, you receive a credit.
Roll Credit in Backwardation
You are long 1 crude oil contract:
- Sell February at $80.00
- Buy March at $79.00
- Roll credit: $1.00 per barrel = $1,000 per contract
Rolling in backwardation adds to your returns over time.
Contango vs Backwardation: Side-by-Side
Quick Comparison
| Feature | Contango | Backwardation |
|---|---|---|
| Curve shape | Upward sloping | Downward sloping |
| Future vs spot | Futures higher than spot | Futures lower than spot |
| Roll yield (long) | Negative (costs money) | Positive (makes money) |
| Market signal | Adequate supply | Supply shortage or strong demand |
Real-World Implications
For Commodity ETFs
Commodity ETFs that hold futures contracts are heavily affected by term structure. In persistent contango, the ETF loses value over time due to negative roll yield, even if spot prices stay flat. This is why oil ETFs often underperform the actual oil price.
For Spread Traders
Calendar spreads profit from changes in term structure. Buying the near month and selling the far month profits when the curve flattens or moves toward backwardation.
For Position Traders
Understanding term structure helps you time your entries and choose which contract month to trade. Sometimes the best value is not in the front month.
How to Identify Contango and Backwardation
- Check futures chain: Look at prices across contract months on your trading platform
- Plot the curve: Many platforms display term structure charts
- Compare to spot: Check if futures trade above or below the cash/spot price
- Track changes: Monitor how the curve changes over time
Trading tip: Markets can shift between contango and backwardation. A market in contango can quickly flip to backwardation during supply disruptions, creating trading opportunities.
Monitor Your Futures Positions
Pro Trader Dashboard helps you track your futures trades and understand the impact of rolling costs on your portfolio performance.
Summary
Contango and backwardation describe the shape of the futures term structure. Contango means higher prices for later months (upward sloping), while backwardation means lower prices for later months (downward sloping). For futures traders, understanding these concepts is essential for managing roll costs, interpreting market signals, and identifying spread opportunities.
Ready to learn more? Check out our guide on rolling futures contracts or learn about commodity futures trading.