Back month contracts

What Are Back Month Contracts?

Back month contracts are futures or options contracts with expiration dates further in the future, as opposed to those expiring in the near term. These financial instruments are a key component of the broader derivatives market, offering participants the ability to lock in prices or manage risk over extended periods. While futures contracts typically list several successive monthly expiration periods, back month contracts refer to those beyond the nearest, or "front month," contract. They are particularly relevant for market participants engaged in long-term planning, hedging, or speculating on future price movements of an underlying asset.

History and Origin

The concept of standardized forward agreements, which paved the way for modern futures contracts and, by extension, back month contracts, emerged from the necessity of managing price volatility in agricultural commodities. In the mid-19th century United States, farmers and merchants faced significant uncertainty regarding future crop prices and availability. To mitigate this risk, they began to enter into "to-arrive" contracts, which were agreements to buy or sell a commodity at a predetermined price on a future date.⁶

The formalization of these arrangements led to the establishment of exchanges like the Chicago Board of Trade (CBOT) in 1848, initially as a cash market for grain.⁵,⁴ The CBOT introduced the first standardized futures contracts in 1865, complete with established rules for trading, margin, and delivery procedures.³,² As these markets matured and expanded beyond agricultural products to include financial instruments, the concept of a series of contracts with varying expiration dates became fundamental, naturally giving rise to the distinction between nearby and back month contracts to facilitate long-term price discovery and risk management.

Key Takeaways

• Back month contracts are derivatives with expiration dates further in the future.
• They are utilized for long-term price discovery, hedging, and speculation.
• Their pricing can reflect market expectations of future supply and demand conditions.
• The relationship between front and back month contract prices reveals market structures like contango or backwardation.
• These contracts are less liquid than front month contracts but offer longer-term exposure.

Interpreting Back Month Contracts

Interpreting back month contracts involves analyzing their prices relative to front month contracts and understanding the implications for the market's outlook. When back month contracts trade at higher prices than nearer-term contracts, the market is said to be in contango. This typically indicates that market participants expect the price of the underlying asset to increase over time, often due to storage costs, interest rates, or anticipated future demand exceeding current supply. Conversely, when back month contracts trade at lower prices than front month contracts, the market is in backwardation. This suggests an expectation of declining prices or a premium placed on immediate availability of the commodity, sometimes seen during periods of short supply.

Traders and analysts closely monitor the price differences across various expiration dates, known as the "term structure" or "futures curve," to gauge market sentiment and potential price trends. The shape of this curve provides insights into the market's assessment of future supply and demand dynamics, influencing hedging strategies and speculation on the underlying asset.

Hypothetical Example

Consider an oil producer wanting to lock in a price for crude oil production expected in six months. The current price of the nearest futures contracts for crude oil (front month) might be $80 per barrel. However, the producer needs to secure a price for oil delivered in six months, which corresponds to a back month contract.

Let's assume the following hypothetical prices for crude oil futures:

• Front Month (August): $80.00
• September: $80.50
• October: $81.00
• November: $81.50
• December: $82.00
• January (the desired back month): $82.50

In this scenario, the market is in contango, as each successive back month contract is priced higher than the previous one. The oil producer can sell January futures contracts at $82.50 per barrel, effectively locking in a price for their future production. This allows the producer to reduce their price risk, even though the actual delivery will occur in the future, demonstrating the practical utility of back month contracts for long-term planning.

Practical Applications

Back month contracts serve several crucial functions across financial markets:

• Long-Term Hedging: Companies involved in the production or consumption of commodities, or those with long-term financial exposures, use back month contracts to mitigate future price risk. For instance, an airline might purchase oil futures expiring 12 months out to lock in fuel costs, reducing the impact of short-term price fluctuations on their operational budget.
• Price Discovery: The prices of back month contracts reflect the market's collective expectation of future supply and demand, long-term macroeconomic trends, and geopolitical developments. They provide a forward-looking benchmark that helps businesses and investors make informed decisions.
• Investment and Speculation: Traders with a long-term view on an underlying asset may use back month contracts for speculation, betting on anticipated price movements that unfold over many months. This can involve positions based on fundamental analysis of future market conditions.
• Arbitrage Opportunities: While less common than in front-month contracts due to lower liquidity, price discrepancies between different back month contracts, or between back month contracts and related financial instruments, can present arbitrage opportunities for sophisticated traders.
• Regulatory Oversight: The trading of back month contracts, like other derivatives, is subject to rigorous oversight by regulatory bodies such as the Commodity Futures Trading Commission (CFTC) in the United States.¹ These agencies work to ensure market integrity, prevent manipulation, and protect market participants. Global trading volume in futures and options reached a record 137.3 billion contracts in 2023, highlighting the expansive use of these instruments.

Limitations and Criticisms

While back month contracts offer valuable tools for risk management and price discovery, they come with certain limitations and criticisms:

• Lower Liquidity: Generally, back month contracts have lower trading volume and open interest compared to front month contracts. This reduced liquidity can lead to wider bid-ask spreads, making it more expensive to enter or exit positions, and potentially making large trades difficult without significantly impacting the price.
• Increased Basis Risk: The price relationship between a futures contract and its underlying spot asset is called the basis. For back month contracts, this basis can be more unpredictable over longer periods, introducing greater basis risk for hedgers. Academic research has highlighted that delivery basis risk can affect the efficiency of futures markets.
• Volatility and Price Spikes: Although typically less volatile than very near-term contracts, back month contracts can still experience significant price swings, especially in response to major macroeconomic shifts, supply shocks, or geopolitical events that alter long-term expectations for the underlying asset.
• Complexity of Rollover: For positions maintained over extended periods, investors must engage in a process called rollover, where an expiring contract is closed and a new position is opened in a further-out contract. This process incurs transaction costs and can lead to "rollover risk" if the market is in a steep contango or backwardation.
• Predictive Accuracy: While back month contracts reflect market expectations, these expectations are not always accurate. Unforeseen events can cause significant divergences between implied future prices and actual spot prices at the time of expiration date.

Back Month Contracts vs. Front Month Contracts

The distinction between back month contracts and front month contracts is primarily based on their time to expiration date. Front month contracts are those that are closest to their expiration date and delivery, typically the current or next expiring month. They are characterized by the highest trading volume and open interest, reflecting their role in immediate price discovery and short-term trading or hedging. Due to their proximity to delivery, they are often more sensitive to immediate supply and demand factors and news events.

In contrast, back month contracts are all contracts with expiration dates further out than the front month. They generally exhibit lower liquidity and are less influenced by day-to-day fluctuations, instead reflecting longer-term market expectations regarding the underlying asset. While front month contracts are crucial for short-term directional plays and immediate physical delivery or settlement, back month contracts are preferred for long-term strategic hedging and speculation that anticipates trends over several months or years. Confusion sometimes arises when traders focus solely on the spot price, failing to appreciate how the entire curve of futures contracts, including back months, provides a holistic view of market sentiment.

FAQs

How far out do back month contracts typically extend?

The range for back month contracts varies significantly depending on the underlying asset and the exchange. For highly liquid commodities or financial instruments, contracts can extend out for several years, while for others, they might only be available for a few quarters. Exchanges list contracts that meet market demand for long-term hedging or speculation.

Why are back month contracts usually less liquid?

Back month contracts are typically less liquid because the majority of trading activity, including speculation and hedging for immediate needs, tends to concentrate in the nearest-term or front month contracts. As a result, back month contracts have fewer buyers and sellers, leading to wider bid-ask spreads and potentially larger price impacts for trades.

Can back month contracts be used for physical delivery?

Yes, depending on the specific futures contracts and exchange rules, back month contracts can lead to physical delivery of the underlying asset if held until their expiration date by parties intending to make or take delivery. However, many traders close their positions or roll them over before expiration to avoid the complexities of the delivery process.

What is the primary advantage of trading back month contracts?

The primary advantage of trading back month contracts is the ability to take a long-term view or hedge long-term price exposures. They allow market participants to secure prices or positions far into the future, providing certainty for budgeting, planning, or long-term investment strategies, especially for producers and consumers of physical commodities.