The commodities trading world can be complex and overwhelming, especially for industry newcomers. There are several key concepts that traders need to understand before diving into the commodities market, one of them being the front-month or near-month contract.
This type of contract is used in futures trading to represent the delivery of a commodity within a specific timeframe. This article will explain what front-month contracts are, how to recognize them, what makes them important, and how they differ from back-month contracts.
What Is a Front-Month Contract?
In commodities trading, futures contracts are agreements between buyers and sellers for the purchase and delivery of a specific asset or commodity at a predetermined price and date in the future. A front-month contract is a futures contract that is the closest to expiration (e.g., its expiration date is closest to the current date).
For example, if the front month contract for crude oil is April, if the trader still holds the contract come April, they would have to take possession of the assets (e.g., execute the trade).
Depending on their strategy and intentions, traders can use front-month contracts for different purposes, such as speculating on the price movements of a commodity and hedging against price risk.
Furthermore, since front-month contracts are closer to expiration, they enjoy high trading activity. Usually, they are among the most liquid contracts in the market. As a result, it makes it easier for traders to buy and sell them at the desired price.
Some of the most common commodities with front-month contracts include crude oil, natural gas, gold, silver, and copper. These contracts are standardized and traded on popular exchanges, such as the New York Mercantile Exchange (NYMEX) or the Chicago Mercantile Exchange (CME).
Recognizing Front-Month Contracts
Front-month contracts can be easily identified by looking at their expiration dates. Most futures exchanges list contract expiration dates for the various commodities they trade. Alternatively, traders can also use trading platforms that highlight the front-month contract for each commodity.
It is important to note that the front-month contract can change as time passes. As the expiration date of the front-month contract approaches, traders will start trading the next contract month, which becomes the new front-month contract. This process is known as contract rollover and typically happens a few days before the expiration date of the front-month contract.
The volume and open interest of the front-month contract are other factors to look up for. Volume refers to the number of contracts that have been traded during a specific time period, while open interest refers to the number of contracts that are outstanding at any given time. High volume and open interest in the front-month contract typically indicate high trading activity and market liquidity.
Example of a Front-Month Contract
In order to better understand how front-month contracts work, let’s take a look at an example.
Suppose a trader wants to buy a front-month contract for gold. The current month is March, and the front-month contract for gold is April. The trader buys the April contract for $1,800 per ounce, expecting the price of gold to increase by the expiration date in April, also known as the delivery date.
If the gold price increases by April, the trader can sell the contract for a profit. However, if the price of gold decreases, the trader may end up losing money. It is important to note that traders can also sell short front-month contracts, which means they are betting that the commodity’s price will drop.
Why Is Understanding the Front-Month Important?
Understanding the front-month contract is crucial because it can impact the price of a commodity. As the expiration date of the front-month contract approaches, traders who hold positions in that contract will need to either close out their positions or roll them over to the next contract month.
This can cause increased trading activity and volatility in the market. A trader who expects increased volatility in the front-month contract may decide to trade the back-month contracts instead.
For that reason, traders should keep in mind the potential impact rollover can have on their trading strategy, as rolling over to a new contract month can cause price distortions in a different trading environment.
For instance, if the front-month contract for crude oil is expiring soon while there is a shortage of the underlying commodity, traders who hold long positions in the contract may try to sell their positions quickly to avoid deliveries. Depending on the scale, this might cause a steep drop in the price of crude oil and provoke a domino effect throughout the industry.
All of the above-mentioned factors are valuable elements for traders to acknowledge in their trading strategies.
What Are Back-Month Contracts?
Back months are futures contracts with expiration dates further in the future than the front month contract. These contracts are also known as deferred months or out months.
This type of futures contract is preferred by traders who want to take a longer-term position in a commodity. Back-month contracts usually are less liquid than front-month contracts, suggesting lower trading activity and wider bid-ask spreads. This, however, can make it more difficult for traders to buy and sell these contracts at their desired price.
On the other hand, back-month contracts can also be less volatile, making them attractive to traders who want to avoid high-risk trades and short-term price fluctuations.
Similar to front-month contracts, back-month ones can also be used for hedging purposes. For example, a commodity producer may want to hedge their production for several months or even years into the future. One of the ways to do this is by selling back month futures contracts that represent the delivery of their commodity at a distant future date.
Another example is a bullish trader expecting the price of crude oil to appreciate over the next several months. To take advantage of it, he may decide to buy a back-month contract for delivery in six months, allowing them to lock in a price, thereby reducing the risk of future price hikes.
Example of a Back-Month Contract
Let’s assume that on March 10, a trader wants to buy a futures contract for crude oil with a delivery date of July 2023. The trader expects the oil price to rise in August, so instead of purchasing the front-month contract of July, the trader opts for a contract that settles further in the future, for example, in October.
In this case, the October contract would be considered a back-month contract, requiring the trader to take delivery of crude oil in that month unless they decide to sell the futures contract sooner.
Front-Month vs. Back-Month Contracts
The key distinction between front-month and back-month contracts is the expiration date. Front-month contracts are the ones closest to expiration, while back-month contracts have expiration dates further away in the future.
Front-month contracts are the most actively traded contracts in the commodity markets. They have a shorter lifespan, usually between one and three months, and are generally more volatile than back-month contracts. Being valid for a shorter period makes them more sensitive to supply and demand changes and other market factors.
On the other hand, back-month contracts have significantly longer expiration periods, between three and twelve months. Along with lower volatility, this makes them more sensitive to longer-term market trends.
Generally, traders use front-month contracts to take advantage of short-term price movements, while back-month contracts help hedge against long-term price risks.
A commodity producer who expects to sell their product six months from now but is afraid of potential factors that might lower the price can sell a back-month contract to lock in a price that will guarantee a profit. Conversely, a trader who believes that the price of a commodity will rise in the short term may buy a front-month contract to sell it before it expires to turn a profit.
These are some of the key differences between front and month contracts. However, traders use each type of contract for different purposes, depending on their trading strategies and the overarching market outlook.
Summary
In conclusion, front-month contracts are a key concept in commodities trading. They represent the contract that is closest to expiration. Being aware of the characteristics and mechanics of front-month contracts is important for traders to make informed trading decisions and adjust their strategies accordingly.
Back-month contracts can be used to take a longer-term view of a commodity and to hedge against future price movements. By understanding the difference between front-month and back-month contracts, traders can better navigate the complexities of commodities trading.
