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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Back Month Contract

What it is:

Also called a far month contract, a back month contract is a futures contract that has an expiration date that is the farthest beyond the next approaching expiration date (called the “front month contract).

How it works (Example):

For example, let’s assume that John Doe wants to buy orange juice futures. It is May 15, and the next orange juice contracts expire on June 30. John thinks the price of orange juice will rise in September, so instead of buying the front month contract (the June contract), he buys a contract that expires as far out as possible -- in this case, December 31. This December contract is a back month contract.

Note that as time passes, a back month contract eventually becomes a front month contract.

Why it Matters:

A futures contract’s liquidity increases as it gets closer to its expiration date because more people want to trade contracts that are near expiration (there are a number of reasons for this, many of which have nothing to do with the demand for the underlying commodity). Nevertheless, in general, analysts believe that the prices of front month contracts are more “accurate” in that they are better indicators of supply and demand.

So although back month contracts can give some indication about what the markets think will happen in the more distant future, liquidity corresponds to risk, and therefore back month contracts, which are less liquid, are also riskier than front month contracts. Because of this risk, back month contract premiums are usually higher than front month contract premiums. Analysts typically look at the difference in price between a front month contract and a back month contract for the same commodity to calculate what’s called a calendar spread.

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