Mastering futures contango and futures backwardation: Core trading strategies of the contract market

In digital asset and commodity futures trading, “contango” and “backwardation” are two crucial concepts. These terms describe the divergence relationship between the contract price and the spot price, which directly affects traders' profit opportunities and risk management strategies.

Contango: Meaning of Futures Premium

Contango occurs when the futures trading price exceeds the expected spot price. In simple terms, investors are purchasing futures contracts at an amount higher than the current market price.

Taking Bitcoin as an example, if the current price is $50,000 and a futures contract expiring in three months is quoted at $55,000, this constitutes a contango phenomenon. Traders are willing to pay a premium for the futures because they are optimistic about the asset's potential for appreciation during the contract period.

Futures Discount: The Substance of Contract Discount

In contrast to contango, futures backwardation refers to the situation where the contract price is lower than the spot price. In a backwardation market, traders accept lower contract quotes, reflecting a pessimistic outlook on future prices.

Assuming the current price of Bitcoin is $50,000, but the Futures Trading contract expiring in three months is only quoted at $45,000, the market is in a state of contango. Investors choose to establish short positions when the Futures Trading is in contango, expecting the price of the underlying asset to decline further.

The Market Drivers of Contango and Backwardation

Causes of Futures Contango: The market is optimistic about future trends, with increased institutional adoption and positive policy news driving up futures prices. Among traditional commodities, storage costs and transportation fees are also major drivers of contango. For digital assets like Bitcoin, shifts in market sentiment are often a direct catalyst for contango.

Contango creates arbitrage opportunities for traders – buy Spot while simultaneously selling Futures Trading to profit from the price difference.

Causes of Futures Discount: Regulatory concerns, negative news, supply issues, or a shift in market expectations to bearish can trigger contango. When traders are pessimistic about the short-term outlook, they are willing to accept contracts at a discounted price, leading to contango formation.

Specifically, as the futures contracts approach the delivery date, short sellers may need to close their contracts to avoid physical delivery, and this closing demand will also deepen the contango.

Practical Thinking of Using Contango and Backwardation in Trading

Contango Market Strategy: In a contango environment, traders can adopt a long strategy by buying futures contracts and holding until expiration. At the same time, arbitrageurs can purchase the underlying asset at a lower spot price and sell it at a higher contract price to lock in the spread. For producers or consumers, buying futures can lock in future prices during contango, mitigating upside risk.

Contango Market Strategy: Contango in futures trading provides a good opportunity for short selling. Traders can sell futures contracts, anticipating further declines in the underlying asset. Likewise, savvy traders can also uncover arbitrage opportunities in a contango market by simultaneously holding a long position in spot and a short position in contracts to secure certain profits.

Furthermore, understanding the interchangeability between contango and backwardation is crucial—changes in market sentiment, news releases, or data announcements can trigger rapid switches between contango and backwardation. Successful traders need to keenly capture these turning points and flexibly adjust their positions between futures trading backwardation and contango to adapt to different market cycles.