Important Trading Concepts to Know: Contango and Backwardation

Contango and backwardation are important concepts to traders, whether they are looking to hedge or speculate. These terms refer to the pattern of prices within a particular market over time and can be a good indicator of market sentiment.

Before we dive into the definitions, remember that futures contracts represent the future value of an underlying asset. When futures are trading above spot value, this indicates a bullish sentiment (prices are rising). When futures are trading below the spot value, this suggests a more bearish sentiment (prices are falling).

 

What is contango?

Contango is a market condition that occurs when the price of a futures contract is higher than the spot price of the underlying asset.

This premium exists when the market expects the future price of the underlying instrument to be higher than the current price. When markets are in contango, a corresponding fall in futures prices can occur as new information aligns the contract value to the expected spot price.”

Contango indicates a bullish market condition as traders are happy to invest in futures contracts at a premium to spot. This creates an appealing opportunity for arbitrage traders who wish to buy the spot and sell the futures contract at higher prices.

As a refresher, futures contracts can expire at a certain date; most often, at the end of the quarter. Some traders opt for shorting the futures contract near expiry. They do so to benefit from the price of the futures contract devaluing and converging with spot.

 

What is backwardation?

Backwardation is a market condition that occurs when the price of a futures contract is lower than the spot price of the underlying asset. This happens when the market expects the future price of the underlying instrument to be lower than the current price.

When markets are in backwardation, traders may utilize this opportunity to adopt long positions. A bullish crypto trader may seek to go long on a futures contract at a lower price. Theoretically, as the futures price converges with spot, holders of long futures positions should profit.

 

Key Takeaways

Contango = Futures contract > Spot price = Bullish Sentiment

Backwardation = Futures contract < Spot price = Bearish Sentiment

 

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