Lessons › Advanced track › Rollover, basis, contango and backwardation

World 10 · Advanced track · lesson 2 · level 4

Rollover, basis, contango and backwardation

A future's price is not the same as today's price, and that gap can cost or earn money when you roll to the next contract.

In one line

Oil's spot price ends the year where it started. Why can a rolled oil futures position still be down?

Explained simply

A futures price is like a pre-order price for a game: it can be higher or lower than the price in the shop today. As release day gets close, the pre-order price and the shop price meet. If you keep swapping into later, pricier pre-orders, you pay that gap again each time.

The lesson

The basis is the gap between the spot price (today's cash price) and the futures price; in commodity markets it is usually written as spot minus futures, and it shrinks toward zero as expiry approaches. When later contracts are priced above nearer ones the market is in contango, and when they are priced below it is in backwardation, which often signals that the asset is scarce right now. Rolling means closing the expiring contract and opening a later one. In contango, a long position that keeps rolling tends to lose value if the spot price stays flat, because each new contract drifts down toward spot as it nears expiry.

A worked example

Illustrative example: spot oil is 70 dollars a barrel. The expiring contract trades at 70 and next month's at 71.50, so the market is in contango, and next month's basis is 70 - 71.50 = -1.50. A long trader rolls by selling the expiring contract at 70 and buying next month's at 71.50. If spot is still 70 when that contract expires, it will have converged to 70, a loss of 71.50 - 70 = 1.50 per barrel, or 1.50 x 1,000 = 1,500 dollars per contract. Twelve rolls like that in a flat year would cost 12 x 1,500 = 18,000 dollars, even though spot never moved.

The same idea at four levels

1. Beginner. A futures price and today's spot price are usually different.
2. Foundation. The gap is called the basis, and it shrinks to about zero at expiry, when futures and spot meet.
3. Intermediate. Contango means later months cost more, and backwardation means later months cost less.
4. Advanced. In steady contango a rolled long position keeps buying a pricier contract and losing that premium as it converges to spot, so it can fall behind the spot price even when spot is flat.
5. Expert. Continuous futures charts stitch contracts together and can jump at each roll, and strange things can happen near expiry, as in April 2020 when the expiring US crude oil contract settled at minus 37.63 dollars a barrel, so roll or close well before the last trading day.

Mistakes to avoid

• Comparing a futures chart with a spot chart and expecting the same prices.
• Forgetting that a continuous futures chart stitches contracts together and can jump at each roll.
• Holding a physically delivered contract into its last trading days by accident.

Goal of this lesson: Explain why futures prices differ from spot prices and what happens when a position is rolled.