Futures premiums and discounts: what determines the dynamics of contango

When you look at the quotes of cryptocurrencies and commodities, you often notice a strange pattern: the price of a futures contract can significantly differ from the current market value. This difference between the future and present price is not just an abstract phenomenon. It is a real mechanism that traders use for profit.

When the market overpays for the future

Contango is a state in which the futures price is quoted higher than the current spot price. Imagine a situation: bitcoin is trading on the spot market for $50 000, but three-month futures contracts are priced at $55 000. This premium of $5 000 is not accidental.

Such a curve structure often forms during optimistic market sentiment. When good news comes in or interest from large investors grows, participants are willing to pay a premium for the right to own the asset in the future. They believe that in three months the price will rise even higher.

But contango in the futures market arises not only from expectations of rise. Storage costs, interest rates, and time also come into play. If you hold physical gold or oil, it incurs expenses. For bitcoin, the costs are minimal, but the time factor remains: traders always demand compensation for delayed delivery.

Arbitration and the Limits of Possibilities

It is precisely in contango that trading opportunities arise. If the futures price is excessively inflated, arbitrageurs can act simply: buy cryptocurrency or a commodity at a low spot price and simultaneously sell a futures contract at a high price. The difference becomes profit.

However, such transactions quickly narrow the gap between prices, equalizing the market. This is a natural self-regulating mechanism.

Opposite side: deficit and haste

Backwardation is the direct opposite of contango. Here, the futures price falls below the spot price. The same bitcoin for $50 000 today may be worth $45 000 in a three-month contract.

Such an inversion occurs when the market is dominated by either fear or urgent demand. If traders are afraid of regulatory changes or expect a price drop, they agree to a discount. Immediate access to the asset under conditions of limited supply becomes more valuable than the prospect of obtaining it later.

Backwardation is also developing for technical reasons. When the expiration date of futures contracts approaches, participants with short positions often rush to buy back contracts to avoid facing physical delivery. This urgent buying can temporarily lead to a reverse structure in the futures market.

How to use these patterns

For active traders, contango and backwardation are not just theories. They are signals that guide strategy.

In contango conditions, one can expect a long-term rise in the underlying asset and open long positions in futures. Producers and consumers of commodities often lock in future prices specifically during contango, protecting themselves from subsequent fluctuations.

In backwardation, the logic changes. It makes sense to take short positions here if you expect a price decline. One of the main tools in a reverse curve is again arbitrage, but the other way around: you sell the spot asset and buy a cheap futures contract.

The main thing is to understand that each structure of the curve reflects the real expectations of the market: its fears, hopes, and liquidity needs.