Contango and Backwardation Explained

Even experienced traders can unwittingly overlook critical factors that can influence the effectiveness of their trading strategies. One such factor is the futures curve, a graphical representation of futures prices for a commodity or financial instrument across different expiration dates. When this curve slopes upward, it's in a state called contango; when it slopes downward, it's called backwardation. 

Contango and backwardation reflect shifts in supply, demand, sentiment, and other market conditions for an underlying asset. For example, supply constraints or spikes in demand can often cause backwardation in crude oil futures, leading traders to expect higher prices in the near term but lower prices over the medium to long term. 

These patterns can help reveal market dynamics for traders and can directly impact the potential profitability and risk of certain trading strategies, from futures hedges to Cboe Volatility Index^® (VIX) options. This makes understanding what drives the shape of a futures curve—and what its state signals—critical before putting any trading strategy into action. 

Contango occurs when the futures price of an asset trades above the expected future spot price for that asset. This relationship leads the futures curve to have an upward slope, with longer-dated futures contracts priced higher than shorter-term ones. 

Contango is generally considered a normal market condition because futures prices typically trade at a premium to spot prices for two main reasons. First, most asset values tend to rise over time due to market expectations for inflation. Second, the delivery of an asset typically involves additional storage and financing costs, called carrying costs, which drive up later-dated futures contract prices. 

Let's look at an example using the paperMoney^® feature of the thinkorswim^® platform. The chart below shows the E-Mini S&P 500 (/ES) futures curve in contango, with longer-dated futures priced above shorter-dated futures. 

Several factors can cause contango, including: 

• Near-term oversupply. When the market holds more of an asset than buyers need, it can push down spot prices, as producers cut prices to move inventory. This leads spot prices to trade lower than futures prices.
• Weak near-term demand. When near-term demand is soft, spot prices also tend to drop. If market participants expect demand to recover, longer-dated futures may remain higher, contributing to contango.
• Bullish investor sentiment. Expectations for rising prices in the future can push longer-term futures prices higher, even if current supply and demand is balanced. Traders anticipating higher prices effectively price this bullish outlook into the futures market.
• Low convenience yield. Convenience yield is the implied benefit of holding physical inventory (rather than a futures contract) for that asset. For example, a food processing company might hold physical bushels of wheat instead of only buying futures contracts to ensure they have a buffer against near-term supply disruptions. When carrying costs are high, or there is abundant supply available, this convenience yield can be low. This makes it more beneficial to buy longer-dated futures instead of buying the physical commodity at the spot market price, leading to contango. 

One of the most poignant examples of a strong contango market came in late 2014, when a rapid increase in U.S. shale crude oil production due to advancements in drilling techniques led to a global oil supply glut. This led spot oil prices and shorter-dated futures prices to plummet relative to longer-dated futures contracts. 

Backwardation occurs when the futures price of an asset trades below the expected future spot price for that asset. A downward-sloping futures curve reflects this relationship, with shorter-dated futures contracts priced higher than longer-dated ones. 

Backwardation is less common for a futures curve. For futures tied to measures of volatility, backwardation can be a sign that concern about immediate risks is plaguing investors' minds. In commodity futures, backwardation can be sparked by geopolitical instability or strong near-term demand. 

The thinkorswim chart below shows the Heating Oil (/HO) futures curve in backwardation, with shorter-dated futures priced above longer-dated futures. 

Several factors can cause backwardation, including: 

• Supply shortages. Near-term supply constraints can lead buyers to pay a premium for immediate delivery of a commodity to meet current needs, pushing spot prices above futures prices. Concerns about future supply availability—caused by things like geopolitical tensions—can have a similar effect, contributing to backwardation.
• Strong near-term demand. When current demand for an asset is high, spot prices tend to rise. If market participants expect demand to return to normal, longer-dated futures may remain lower, leading to backwardation.
• Bearish investor sentiment. If market participants expect prices to decline in the future, futures prices may decline even if supply and demand are in balance. Traders anticipating lower prices effectively price this outlook into futures.
• High convenience yield. When inventories or carrying costs are low, the convenience yield can rise. This makes it more beneficial to buy at spot prices rather than futures prices, pushing up spot prices. 

One of the best examples of backwardation came after Russia slashed its natural gas deliveries to Europe in 2021. This action led spot natural gas prices to spike, while longer-dated futures contracts remained relatively low as the market priced in a normalization of supply conditions over time. 

As futures contracts near expiration, the gap between spot and futures prices tends to narrow in a process known as convergence. This happens because the factors that cause futures prices to differ from spot prices—like the threat of carrying costs—fade as the delivery date nears. 

At a futures contract's expiration date, its price is almost always roughly equal to the spot price. If these prices aren't equal, it's a potential arbitrage opportunity because traders can buy an underlying asset at a lower spot price and then sell that asset at the higher futures price—or vice versa. Convergence can impact different trading strategies, including futures hedging strategies, spread trades, and more. 

The slope of a futures curve—whether in contango or backwardation—isn't just a reflection of supply and demand dynamics or market sentiment. It can also directly influence the profitability, risk, and effectiveness of trading strategies. 

For example, a futures curve in contango can increase the cost of using futures to hedge a long position in an equity index. When longer-dated futures prices are higher than shorter-dated ones, it's more expensive each time a trader rolls their futures position forward by selling an expiring contract and buying a new longer-dated one. That can weigh on returns over time. 

On the other hand, a futures curve in backwardation can decrease the cost of hedging a long position in an equity index. When shorter-dated futures prices are lower than longer-dated ones, it's less expensive each time a trader rolls their futures position forward. That leads to a cheaper hedge over time. 

Beyond hedging, the shape of a futures curve can influence a wide range of trading strategies. It plays a role in calendar spreads, arbitrage trades, and even volatility trades tied to the VIX. Each of these strategies respond differently to shifts in the curve's slope, which is why understanding how contango and backwardation develop—and how they change over time—may help traders interpret market behavior more clearly and manage risk more effectively. 

Contango and backwardation aren't only relevant for the futures market. In the options market, for example, these concepts are applied to the term structure of implied volatility (IV)—or how an options contract's IV changes across different expiration dates. IV measures the market's expectations of how much an asset's value is forecast to change, based on the price of its options. 

In contango, IV for longer-dated options is higher than it is for shorter-dated options. In backwardation, IV for shorter-dated options is higher than for longer-dated options. Contango is considered a normal state of the options market, where there is greater uncertainty about how much an asset's value will change further into the future. Backwardation in the options market, on the other hand, often reflects increased fear or uncertainty in the short term. 

Understanding the concepts of contango and backwardation is essential for traders. This knowledge can provide insights into shifts in sentiment, supply, and demand, helping traders better understand the markets they trade. By being aware of these conditions, traders may also be able to more effectively anticipate costs, manage risks, and decide which trading strategies are worth implementing at any given time.