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Contango and Backwardation

The concepts of Contango and Backwardation are related with the term structure of the futures contracts. During the life of a contract, the difference between the futures price and the expected future price is called basis. At the end of the contract’s life, the futures price converges to the expected future spot price. Each month, the future price is updated with respect to the expectations and the basis is erased. 

If the contract futures price is above the future expected spot price, the scenario is called Contango, and if the contract futures price is below the future expected spot price the scenario is called Backwardation

In Contango, the futures price decline over time to be adjusted to the expected future spot price as both must converge at expiration. In contrast, in Backwardation, futures prices tend to be below expected futures spot prices, so the futures prices go up to converge with the expected futures spot prices.

Backwardation is beneficial for traders who have a long position on the stock, as the contract future price would increase over time.For commodity assets, Backwardation is produced when there is a shortage in the commodity supply. In this situation, traders can benefit by performing a short sale of the asset at the spot price, and go long on futures contracts waiting for an increase in the future price.

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