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

Back Months

What it is:

Back months are the expiration dates of futures contracts that fall furthest from the nearest expiration date.
 

How it works (Example):

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

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” because they are better indicators of supply and demand. Note that as time passes, a back month contract eventually becomes a front month contract.

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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