How contango and backwardation affect futures trading

Futures contract quotes rarely match the spot prices of the underlying assets. This difference between what is paid here and now, and what is expected to be received in the future, creates two opposing market situations: contango and backwardation. Both phenomena create trading opportunities and define the strategies of market participants.

When Futures are More Expensive than Spot: The Mechanics of Contango

Contango occurs when the prices of futures contracts rise above current spot prices. If Bitcoin is currently trading at $50 000, and three-month futures are priced at $55 000, this is a classic example of contango. Market participants are willing to overpay for future contracts because they anticipate a price increase of the asset in the coming months.

Such a situation arises under the influence of several factors. Optimistic market expectations, driven by positive news or growing interest from major investors, push demand for futures upward. For physical commodities — oil, grain, metals — storage and transportation costs are added to this. Even for digital assets like Bitcoin, indirect costs can affect the size of the premium.

Arbitrage schemes in contango

When contango is pronounced enough, traders take advantage of the difference between prices. The scheme is simple: they buy the physical asset at a low spot price and simultaneously sell expensive futures contracts. By the time the contract expires, the demand is neutralized, and the price difference becomes profit.

Producers and consumers of underlying assets use contango differently: they lock in future prices, protecting themselves from unfavorable market movements. This allows for planning costs or revenues with greater certainty.

Inverted situation: how backwardation works

Backwardation is the opposite phenomenon. Futures quotes fall below spot prices, and the contract is traded at a discount. If the same bitcoin is worth $50 000 on the spot, and the three-month futures are valued at $45 000, the market is in a state of backwardation.

Traders agree to cheap futures because they expect a price drop. Pessimistic forecasts due to legislative threats, negative news, or concerns about the macroeconomic situation are putting pressure on demand for future contracts.

Factors Causing Backwardation

The supply deficit is another key trigger. When the availability of the asset ( unexpectedly decreases due to natural disasters, production disruptions ), immediate demand surges sharply. Traders are willing to pay a premium for instant access to the limited supply, resulting in spot prices rising while futures lag behind.

As the expiration date of a futures contract approaches, traders with short positions rush to close their obligations and avoid physical delivery. This cumulative demand for near-term contracts can deepen the contango in longer durations.

Trading Strategies in Backwardation

In a backwardation market, the opposite strategy is logical: selling futures in anticipation of a further decline in the asset's price. Similarly to contango, there are also arbitrage opportunities here: buying cheap futures and selling expensive spots, if such a gap is large enough.

Hedgers use backwardation to protect against the risk of falling prices by selling futures contracts and ensuring themselves a minimum price in the future.

Practical Application in Trading

Both states — contango and backwardation in the futures market — provide traders with tools for building strategies. In contango conditions, long positions are opened, betting on growth, or arbitrage schemes are executed. In backwardation, shorts are chosen or opposite arbitrage combinations are used.

The essence is that contango and backwardation are not just price anomalies, but a reflection of the market's collective expectations. Those who learn to read these signals and adapt their positions accordingly gain a significant advantage in futures trading.