Backwardation and Contango

Backwardation and Contango are two popular futures trading terms which are just opposite to one another. Both are theories regarding the futures contact price and expiration rate.

Backwardation is the situation where the future contract price is lower than the spot price for a commodity. As the futures contract approaches maturity, it will trade at higher and higher prices to finally meet the future spot price. Backwardation is evident when underlying commodity is perishable and/or is a software commodity. It is characterized by a downward slopping futures curved, which is referred as ‘backwardated’. John Maynard called backwardation in futures market by term “normal backwardation”, believing backwardation is a natural phenomenon; not a random one.

Contango is the situation where the future contract price is higher than the spot price for a commodity. So, as the futures contract approaches maturity, it will trade at lower and lower prices to finally meet the future spot price. Contango pattern is evident when the underlying commodity is non-perishable and has a cost-of-carry such as financing costs, storage costs and insurance costs. One good example is the gold futures. Contango is characterized by an upward slopping futures curve, which is referred as ‘in contango’ or ‘contangoed’.

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