The market not being a constant phenomenon is subjected to change and thus leads to different market conditions. Some of these phases are quite common that we come across like bullish, bearish, etc. Contango and Backwardation (also referred to as inwardation) are two different kinds of situations that prevail in the market. Let us see both these situations in detail with the help of an example.
Contango is the type of market condition where the future price of a commodity is greater than the spot price of that commodity i.e. F0 > S0. For example, say the spot price of gold is 50000 (S0) and the investor evaluated that the price after 3 months of gold according to interest rate and other factors will be 51000(F0). Thus, in such a case the future is greater than the spot and is thus referred to as the situation of Contango. Such type of situation mainly exists for bullions i.e. gold and silver.
Backwardation is a type of market condition when the future price is less than the spot price i.e. F0 < S0. For instance, say the price of crude oil be 5000 per barrel (S0) and we evaluated the future price according to the interest rate and time period that after 3 months the price will be 4500 per barrel (F0). Thus, when the future is less than the spot it is known as backwardation. This mainly exists for crude oil because of government policies.
It is a more complex concept and requires a deeper understanding of S0 and F0. The point to be noted here is that the subscript of S and F which is the same and that is 0. It signifies that the spot price, say is 100 and we evaluated the future price today for a future date, say after 3 months which is F0. Thus, it is not sure or an accurate price as the market is highly volatile and we are just expecting the future price and indeed the price after 3 months can be higher or lower or even the same as our expected price i.e. F0.
To understand normal contango and normal backwardation, it is important to understand one more representation and that is E(St). So, what does this signify? It basically signifies the actual future price of a commodity after some time (which we are taking as 3 months in each case). Since the future price of today is the spot price at the expiry so at the end of maturity time i.e. after 3 months, the actual price may be the same as F0 or more or less than it.
Now let us look at normal contango and normal backwardation.
Say the price of gold is 50000 which is S0 and we estimated the F0 as say 51000 after 3 months. After 3 months there are two possibilities:
In such a case, say the price after 3 months is greater than our estimation, say 52000. In such a case, it is referred to as the situation of normal contango. Expressing numerically, it refers to a situation when E(St) is greater than F0.
In such a case, say the price after 3 months is less than that of our estimation, say it is 50500. Thus, it is referred to as the situation of normal backwardation. Expressing numerically: E(St) is less than F0.
Thus, the meaning of normal contango and normal backwardation is clear from the graph.