Back months

What Are Back Months?

"Back months" refer to the expiration dates of futures contracts or options contracts that are further in the future, beyond the nearest or "front month" contract. In the realm of derivatives trading, specifically within futures and options trading, a series of contracts for a given underlying asset will typically trade with various expiration dates. The contract with the nearest expiration date is known as the front month, while all subsequent contract months are considered back months. These longer-dated contracts are crucial for market participants looking to plan for future supply and demand, manage long-term price risk through hedging, or engage in longer-term speculation.

History and Origin

The concept of standardized future delivery contracts, which are the basis for understanding back months, emerged from the need to manage price volatility and ensure supply in agricultural markets. Early forms of forward contracts existed for centuries, with records from ancient Mesopotamia and the Dojima Rice Exchange in 17th-century Japan. The modern era of organized futures trading in the United States began with the establishment of the Chicago Board of Trade (CBOT) in 1848. Initially, the CBOT facilitated "to-arrive" contracts for grains, which were agreements to deliver commodities at a future date. By 1865, the CBOT introduced standardized futures contracts, formally creating a marketplace where agreements for future delivery could be traded with specific terms and conditions.

This standardization paved the way for the development of continuous contract series, where multiple delivery months existed for the same commodity. As financial markets evolved, beyond just agricultural products, so did the futures markets. In 1972, the Chicago Mercantile Exchange (CME) launched the first financial futures contracts, including those on foreign currencies. The expansion into financial futures meant that the practice of trading different contract months, including back months, became integral to managing exposure to interest rates, currencies, and stock indexes. The regulatory oversight of these markets, particularly by agencies like the Commodity Futures Trading Commission (CFTC) established in 1974, further solidified the structure and integrity of futures trading across various expiration cycles.

Key Takeaways

• Back months refer to futures or options contracts with expiration dates further in the future than the nearest "front month" contract.
• They provide a means for market participants to express views or manage risk over longer time horizons.
• The price relationships between back months and front months (e.g., contango or backwardation) offer insights into market expectations for supply and demand.
• Trading in back months often involves lower daily trading volume and open interest compared to front months, but can still be highly liquid for commonly traded assets.

Formula and Calculation

While there isn't a single universal "formula" for back months themselves, their pricing relative to the front month is often influenced by carrying costs and market expectations. For commodity futures, the theoretical price relationship between two different contract months ( (F_1) for the nearby month and (F_2) for a back month) can be approximated by:

Where:

• (F_2) = Price of the back month futures contract
• (F_1) = Price of the front month (or nearby) futures contract
• (e) = Euler's number (approximately 2.71828)
• (r) = Risk-free interest rate (e.g., using a relevant Treasury bill rate)
• (StorageCosts) = Costs associated with storing the underlying commodity until the back month expiration
• (ConvenienceYield) = The benefit of holding the physical commodity (e.g., ability to meet unexpected demand)
• (T_2 - T_1) = Time difference between the expiration of the back month and the front month, expressed in years.

This formula highlights that the price difference between contract months generally reflects the cost of carrying the underlying asset forward in time. If the back month is priced higher than the front month, the market is in contango. Conversely, if the back month is priced lower, it indicates backwardation.

Interpreting the Back Months

The prices of back months provide valuable information about long-term market sentiment and expectations. When analyzing back months, traders and analysts often look at the spread between different contract months.

• Normal Contango: If back months are trading at progressively higher prices than the front month, it suggests that market participants anticipate higher future costs of holding the asset or expect future demand to outstrip supply, leading to higher prices in the future. This is common in many commodity futures markets due to storage costs and interest rates.
• Backwardation: If back months are trading at progressively lower prices than the front month, it can signal current supply shortages, strong immediate demand, or expectations of declining prices in the future. This is often seen in markets experiencing tight supply conditions.

Investors use the shape of the futures curve (a plot of futures prices across different expiration dates) to inform their strategies, whether for hedging, speculating, or assessing overall market health.

Hypothetical Example

Imagine a hypothetical oil futures market.

• Current Date: July 25, 2025
• Front Month Contract (August 2025 Crude Oil): Trading at $80.00 per barrel.
• Back Month Contract 1 (September 2025 Crude Oil): Trading at $80.50 per barrel.
• Back Month Contract 2 (December 2025 Crude Oil): Trading at $81.75 per barrel.

In this scenario, the market is in contango, as each successive back month is priced higher than the preceding one. A portfolio manager who believes oil prices will rise significantly by December 2025 might buy the December 2025 futures contract, while a refiner looking to lock in costs for crude oil they will need in September might buy the September 2025 contract. A speculation strategy might involve buying the December contract and simultaneously selling the August contract, betting on the widening of the spread or a rise in absolute prices over time.

Practical Applications

Back months play several critical roles across financial markets:

• Long-Term Hedging: Businesses can use back months to lock in prices for future purchases or sales of commodities, raw materials, or currencies, providing long-term price stability. For example, an airline might buy heating oil futures contracts with expiration dates several months or a year out to hedge against rising fuel costs.
• Investment and Portfolio Management: Fund managers and institutional investors may use back months to gain exposure to an asset class without holding the physical asset, or to implement long-term thematic investment strategies. This is particularly relevant for commodities or fixed income, where financial futures offer efficient access.
• Price Discovery: The prices of back months reflect the collective expectations of thousands of market participants regarding future supply and demand dynamics, interest rates, and other economic factors. This contributes to the overall price discovery process for a given asset. Market participants can access this data directly from exchanges like CME Group.
• Arbitrage and Spreads: Traders can exploit temporary inefficiencies in the pricing relationships between different contract months, engaging in spread trades (e.g., buying one month and selling another) to profit from anticipated changes in the yield curve or term structure. The phenomenon of contango in oil markets, for instance, can lead to specific trading opportunities.¹

Limitations and Criticisms

While useful, trading in back months carries certain considerations and limitations:

• Liquidity: Generally, back month contracts tend to have lower trading volume and open interest compared to the front month. This can lead to wider bid-ask spreads, making it more expensive to enter or exit positions, especially for large orders. Lower liquidity might also result in larger price swings from relatively small trades.
• Contango and Roll Yield: In a contango market, where back months are more expensive than the front month, investors holding long positions must "roll over" their contracts as the front month approaches expiration. This involves selling the expiring front month contract and buying the next back month contract. This "roll yield" can be negative, as the investor is consistently selling a lower-priced contract and buying a higher-priced one, eroding returns over time. This is a common phenomenon in markets like crude oil, as noted by Reuters analyses.
• Predictive Accuracy: While back month prices reflect future expectations, these expectations are not always accurate. Unforeseen geopolitical events, technological advancements, or sudden shifts in supply or demand can cause significant deviations from projected prices, leading to losses for those who relied on the initial back month pricing.
• Margin Requirements: Like all futures contracts, back month contracts require maintenance of margin accounts. Significant adverse price movements can lead to margin calls, requiring additional capital to be deposited or positions to be liquidated.

Back Months vs. Front Month

The distinction between back months and the front month is fundamental in derivatives trading.

Confusion often arises because the "front month" is constantly changing. As one contract expires, the next nearest contract assumes the role of the front month, and all subsequent contracts remain the back months. Understanding this dynamic is crucial for effective management of futures and options contracts over time.

FAQs

What determines the prices of back months?

The prices of back months in futures contracts are primarily determined by the spot price of the underlying asset, the cost of carrying that asset (including interest rates and storage costs), and market expectations about future supply and demand, often reflected in the market's structure of contango or backwardation.

Why are back months important for hedging?

Back months are important for hedging because they allow businesses and investors to lock in prices for transactions that will occur further in the future. This enables them to manage long-term price risk for raw materials, energy, or other assets, providing greater predictability for their future costs or revenues.

Do back months always have lower liquidity?

Generally, back months tend to have lower trading volume and open interest compared to the front month contract. However, liquidity can vary significantly depending on the specific asset, market conditions, and overall interest in longer-dated derivatives. Highly traded commodities or financial instruments might still have substantial liquidity in their back months.

How do back months relate to "rolling over" a position?

"Rolling over" a position refers to the process where a trader closes an expiring futures contract (the current front month) and simultaneously opens a new position in a further-dated contract (a back month) for the same underlying asset. This allows them to maintain their market exposure beyond the initial expiration date.

Can I trade back months in any market?

Back months are a feature primarily of markets that trade standardized futures contracts and options contracts with multiple expiration cycles. This includes commodities (like oil, gold, grains), financial instruments (like interest rates, currencies, stock indexes), and certain other derivatives products. Availability of back months depends on the specific exchange and the product listed.