Back month futures: Meaning, Criticisms & Real-World Uses

What Is Back Month Futures?

Back month futures refer to futures contracts with an expiration date far into the future, as opposed to "front month" or "nearby" contracts that are set to expire sooner. These contracts are a key component of derivatives trading and provide insights into longer-term market expectations. In the realm of financial instruments, futures contracts are standardized agreements to buy or sell an asset at a predetermined price on a specific future date. The distinction between different contract months is crucial for understanding market sentiment, carrying costs, and potential price movements over time. Back month futures play a significant role in strategies like hedging and speculation, as they allow participants to take positions based on their outlook for future supply and demand conditions.

History and Origin

The concept of trading for future delivery has roots in ancient agricultural markets, where farmers and merchants sought to manage price risk for crops not yet harvested. Formalized commodity markets with standardized futures contracts began to emerge in the mid-19th century, particularly in Chicago, to facilitate the trade of agricultural products like grain. The development of these markets naturally led to the listing of contracts with various delivery dates. Participants needed ways to lock in prices for distant periods, giving rise to the importance of back month futures. Over time, as futures markets expanded beyond agricultural goods to include financial assets and energy products, the practice of listing and trading contracts across a spectrum of maturities became standard. Regulatory bodies, such as the Commodity Futures Trading Commission (CFTC), established in 1974, and self-regulatory organizations like the National Futures Association (NFA), were created to oversee these markets, ensuring fair practices and transparent price discovery across all contract months.

Key Takeaways

Back month futures are contracts with expiration dates further in the future compared to nearer-term contracts.
They reflect market expectations for the underlying asset's price at a more distant point in time.
The relationship between back month futures prices and front month futures prices can indicate market conditions like contango or backwardation.
Traders and hedgers use back month futures for long-term price risk management and speculative positioning.
Back month futures generally exhibit lower liquidity compared to front month contracts.

Interpreting Back Month Futures

The pricing of back month futures provides valuable insights into how market participants view the long-term outlook for a particular asset. When the price of back month futures is higher than that of front month futures, this market condition is known as contango. Contango typically suggests that market participants expect the spot price of the asset to rise over time, reflecting factors such as storage costs, interest rates, and convenience yield. Conversely, when back month futures prices are lower than front month futures prices, the market is said to be in backwardation. Backwardation often indicates current supply shortages or high immediate demand, leading to higher prices for immediate delivery. Understanding these relationships is critical for anyone involved in futures markets, whether for hedging purposes or pure speculation.

Hypothetical Example

Consider an oil producer planning their production for the next year. It is currently July. The producer anticipates selling a certain quantity of crude oil in March of the following year.

Identify the need: The producer wants to lock in a price for their March oil sales to protect against a potential drop in oil prices.
Locate relevant contracts: They would look at the crude oil futures contract listed on an exchange like the CME Group. While they might see contracts for August, September, and October (front months), they specifically need the "March next year" contract, which is a back month future.
Analyze the price: Suppose the current spot price of crude oil is $80 per barrel. The August (front month) futures contract might be trading at $81, while the March next year (back month) futures contract is trading at $83. This indicates a contango market, suggesting the market expects oil prices to be higher in March.
Execute the trade: The producer sells March next year crude oil futures contracts at $83 per barrel, effectively hedging their future production. This locks in a price, mitigating the risk of price declines by the time their oil is ready for sale in March.

This example illustrates how a back month future allows the producer to manage risk over an extended period.

Practical Applications

Back month futures are essential for various participants in financial markets due to their capacity to manage future price risk and facilitate long-term planning.

Hedging: Producers and consumers of commodities (e.g., airlines hedging fuel costs, farmers hedging crop prices) use back month futures to lock in future selling or buying prices, thereby protecting against adverse price movements. For instance, an airline might buy crude oil back month futures to fix its fuel costs for the upcoming year.
Speculation: Traders with a long-term view on an asset's price direction can take positions in back month futures. If a speculator believes that a particular commodity's price will significantly increase in six months, they might buy a back month future rather than a nearby one to capitalize on that anticipated movement.
Investment Portfolio Management: Some investment funds and institutional investors use back month futures to gain exposure to commodities or other asset classes without holding the physical asset, offering diversification benefits to their financial instrument portfolios.
Arbitrage: Opportunities may arise from temporary price discrepancies between different contract months. Sophisticated traders may engage in arbitrage strategies by simultaneously buying and selling different futures contracts to profit from these inefficiencies.
Price Discovery: Back month futures contribute to the overall price discovery process in markets, providing benchmarks for longer-term supply and demand expectations. The CME Group, for example, lists various futures contracts, including back months, that aid in this process for a wide range of assets³.

Limitations and Criticisms

While back month futures offer distinct advantages, they also come with limitations and criticisms. One primary concern is their typically lower liquidity compared to front month contracts. This means that trading back month futures can result in wider bid-ask spreads and potentially larger price impacts for significant trades, making it harder to enter or exit positions quickly without affecting the market price.

Another limitation relates to the accuracy of long-term price forecasting. While futures prices are often considered forecasts of future spot prices, their accuracy can be debated, especially for distant maturities. Academic research on market efficiency in commodity futures markets has yielded mixed results, with some studies suggesting that expected excess returns to futures speculation are not always zero, which could imply the presence of a risk premium or inefficiencies over the long run¹, ². Furthermore, unexpected global events, geopolitical shifts, or sudden economic changes can drastically alter supply and demand fundamentals, rendering long-term price expectations embedded in back month futures less reliable. Participants in these markets must account for these uncertainties and the inherent risks associated with long-duration exposures.

Back Month Futures vs. Front Month Futures

The distinction between back month futures and front month futures is fundamental in derivatives trading. Front month futures, also known as nearby futures, are contracts with the closest expiration date. These contracts typically have the highest trading volume and liquidity because they represent the most immediate future delivery or settlement. Their prices are highly sensitive to current supply and demand dynamics, breaking news, and short-term market sentiment for the underlying asset.

In contrast, back month futures have expiration dates further out in time. While still reflecting market expectations, their prices are more influenced by long-term fundamental factors such as projected production, anticipated consumption trends, long-term geopolitical stability, and broader economic forecasts. They generally exhibit lower trading volume and liquidity compared to their front month counterparts. The price relationship between front and back month futures — whether the market is in contango or backwardation — provides a snapshot of the market's collective long-term versus short-term outlook for the underlying asset's price evolution. Traders often use this spread to execute calendar spreads, betting on changes in the relationship between these different maturities rather than on the outright price movement of a single contract.

FAQs

What determines the price of back month futures?

The price of back month futures is primarily determined by the market's long-term expectations for the underlying asset's supply and demand, taking into account factors like interest rates, storage costs for physical commodities, and a potential risk premium that compensates for holding risk over a longer period.

Are back month futures less liquid than front month futures?

Yes, typically, back month futures are less liquid than front month futures. Contracts closer to their delivery month tend to attract more trading activity and therefore have higher liquidity, narrower bid-ask spreads, and easier execution.

Can back month futures be used for long-term investing?

Back month futures can be used by investors looking for long-term exposure to an asset's price movements without taking physical delivery. However, this involves rolling over contracts as they approach expiration, which can incur costs due to the bid-ask spread and potentially market structure effects like contango.

What is a "calendar spread" in relation to back month futures?

A calendar spread is a futures trading strategy that involves simultaneously buying one futures contract and selling another futures contract for the same underlying asset but with different expiration dates. For example, buying a back month future and selling a front month future to profit from changes in their price relationship.