Contango and backwardation strategy (explained!)

Contango is a situation in the market where an asset or commodity has a future price that tends to be more than the spot price as maturity approaches. Defined, the whole aim of the Contango Strategy is that the futures price will converge with the spot price as the delivery date arrives.

Contango can be further viewed as the typical market expectations for a futures contract. This happens because the future asset price will traditionally account for the spot price and the “cost of carrying.” This makes it more than the spot price, based on the maturity time.

A graph showing Contango in detail with the spot price and the futures price

What is a backwardation strategy?

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The Backwardation Strategy is the opposite of Contango. In Backwardation, the market experiences a commodity’s lower futures price than the spot price. Backwardation is often confused with an inverted futures curve which is wrong. 

When the spot price of a commodity or asset becomes higher than the future price, such commodity or asset is said to be in Backwardation. This is often due to the scarcity of commodities in the market.

Backwardation is shown in a graph with clear pointers from the position of the spot price to the futures price

Contango vs backwardation; the trading trends

Traders can employ any of these strategies to reach their goals. Investors often take advantage of Contango or Backwardation when speculating the futures price of an asset with the spot price at maturity. 

Market conditions and trends are needed for traders to make smart trading decisions, especially on whether to go long or short. This is achieved by carefully monitoring the expected price movements of commodities and market factors. The ultimate goal is to profit as the futures price and spot price converge on the delivery date.

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In Contango, investors are willing to invest more in a commodity with an eye on its future spot price or wait for an arbitrage. A Contango may be allowed to depreciate the underlying asset’s value as it approaches expiration. Often, traders do this to buy a commodity to sell off at a higher future price. Traders can also decide to swap markets to sell commodities with their price differences or movements.

Contango vs. Backwardation

This trading mechanism influences the flow or the downflow of the market predicated on the probability of convergence. Notably, when the market is in Contango, traders sell more as it is in premium, while during Backwardation, traders tend to buy more. This is because, in Contango, there is a current surplus in supply, while in backwardation, the demand is in surplus.

Is backwardation bullish?

Backwardation is not bullish in itself since there is no increase in the commodity price. It depends on how a trader approaches the market. If a trader, due to desperation, indulges in selling off without careful monitoring, the market might seem bullish to the trader. However, if a trader accurately defines when to buy and accumulates the cost of carrying with the eventual convergence, he will profit from the market.

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Moreover, the contract delivery time can also influence the nature of the Backwardation. If it is a short-term Backwardation, traders expect supply to ramp up while it lingers, which can incur severe inflations, making the Backwardation Bullish.

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Is backwardation bearish?

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Backwardation is Bearish if short-term but will turn bullish over an extended period. Moreover, a trader’s approach to the market can decide how a trading strategy like Contango vs. Backwardation will turn out for him.

In other words, Backwardation is Bearish but will turn bullish in arbitrage as it reaches futures contract delivery.

In conclusion

For effective financial modeling, a trader should approach the market with the right attitude. Astuteness is needed when monitoring and exploring an underlying asset’s price movements and supply. Traders who may not want to harness the market’s potential during Contango or Backwardation can annex the profits in arbitrage.

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