Patterns over time
While a futures curve presents a snapshot in time — a fixed representation of futures prices against contract maturities — contango and backwardation are observed over time and exist depending on whether futures prices are rising or falling.
Contango and normal backwardation are influenced by differences in the futures price and the spot price for a given commodity — a difference known as the “basis.” The price of a futures contract — whether it is above or below the spot price — will converge to the spot price as its expiration date approaches. This is called convergence. The futures price and spot price converge because of arbitrage, supply and demand. Here’s an example of how it works:
- Assume silver futures are trading above the spot price.
- Traders short silver futures and buy the underlying to take advantage of the arbitrage opportunity.
- The shorting of the futures contracts increases the supply of contracts, which results in a drop in futures prices (more supply = lower prices).
- The buying of the underlying increases the demand, which results in an increase in spot prices.
- As this continues, futures and spot prices eventually converge.
If a contract is above the spot price, price eventually will move down to be in line with the spot price. Because price must converge with the spot price upon expiration, contango implies that futures prices must fall over time.
A market is said to be in backwardation when the futures price is less than the expected future spot price. Again, because price must converge with the spot price as expiration draws near, backwardation implies that the futures price must rise over time.