Contango: how futures premiums influence traders' strategies

Contango is a market phenomenon in futures trading that occurs when the price of a futures contract with a future expiration date exceeds the current spot price of the commodity. Essentially, it is a premium that market participants are willing to pay for the opportunity to buy the asset later. Conversely, there is an opposite process — backwardation, when futures contracts are traded below current spot prices.

The Mechanism of Contango in Practice

Imagine: Bitcoin is trading on the spot market at $50 000, but three-month futures contracts are priced at $55 000. This discrepancy is exactly what contango is. Participants are willing to overpay because they expect the price of the underlying asset to rise in the coming months.

Contango is most often a result of optimistic market sentiment. When investors believe in an upcoming price increase, they buy futures contracts, creating demand and pushing prices higher. In commodity markets like (oil, gold, agricultural products), contango is further amplified by storage and logistics costs that traders incorporate into the contract price.

Backwardation: When the Market is Fearful

Backwardation is the flip side. If the same Bitcoin, with a spot price of $50 000, has three-month futures contracts at $45 000, this is backwardation. Traders are willing to accept a discount because they fear a price decline in the near future.

Factors leading to backwardation vary: bad news, regulatory changes, expectations of decreased demand. If a sharp shortage appears, participants may agree to a discount on future deliveries for immediate access to limited supply. Additionally, as the contract expiration date approaches, traders in short positions often buy back their contracts to avoid physical delivery, further suppressing futures prices.

Practical Application: How to Profit from These Phenomena

Contango is not just a market phenomenon — it presents profit opportunities. If the futures price is significantly higher than the spot price, traders can use arbitrage: buy the physical asset at the low current price and sell the futures contract at the high price, locking in the difference.

Manufacturers and consumers use these mechanisms for hedging. An oil producer can lock in a future price through futures contracts, protecting against potential price drops. Similarly, a factory consuming raw materials can hedge against rising costs by purchasing contracts.

In the backwardation market, the logic works in reverse: short positions become more profitable, and experienced traders look for opportunities to sell futures contracts, expecting further declines in the underlying asset’s price.

Key Understanding

Contango is an indicator of market expectations of growth, while backwardation signals fear and conservatism. For successful trading in the futures market, it is important to recognize these states and adapt strategies accordingly. Each phenomenon offers its own opportunities: contango attracts speculators on the rise and arbitrageurs, while backwardation becomes a field for portfolio protection and short positions.