[Derivative ABC] What Are Backwardation and Contango?

Source: Naver Financial Dictionary

[Asia Economy Reporter Jihwan Park] Futures trading refers to a contract to deliver the underlying asset at a predetermined price at a future date. In this case, the futures price is determined by adding the cost of carrying the underlying asset until the specified future date to the spot price. At this point, a price difference occurs between the futures and the spot price, which is called the 'basis.'

Theoretically, the futures price is higher than the spot price, so in a normal market, the basis has a positive value. A market where the basis is positive is called 'contango.' Conversely, if the basis is negative (-), it means the futures price is undervalued compared to the spot price, and this market condition is called 'backwardation.'

The basis is a very important investment indicator in the futures market because it determines the direction of program trading, which is arbitrage trading. Program trading profits by exploiting the price difference between futures and spot prices. It involves selling the higher-priced asset and simultaneously buying the lower-priced one.

An expanding basis means that the futures price is overvalued and the spot price is undervalued, leading to program buying of the spot asset. In other words, there is a high possibility that the spot price will rise in the future.

Conversely, if the basis is shrinking, it means the spot price is overvalued and the futures price is undervalued, leading to program selling of the spot asset and a high likelihood of a decline in the spot price.