Spread trading: contango or backwardation?

“Regarding contango and backwardation, I wanted to ask you a question: I understand that for a sell spread, for example SBN23-SBV23 (I sell July and buy October), contango occurs when the spread is below zero (i.e., when the price is a negative) and backwardation in the positive (so above zero). I would like to know: would it be the other way around with the spread in the purchase? So, when I am long on a spread the contango is when the spread is in the positive and vice versa the backwardation?”

Concerning contango and backwardation, I have seen that several people have doubts. When a spread is below zero, is it in contango or in backwardation? It depends.

It depends on how that spread is constructed. Typically, a spread is constructed with the nearest delivery in the first leg and the furthest delivery in the second. An example is SBN23-SBV23, the July delivery will expire before the October delivery. So, if the spread is priced above zero it is in backwardation, if below zero in contango. This is regardless of what you do with that spread (whether you buy it or sell it).

Why? Because the further away the delivery, the higher the price because, in addition to the price of the commodity, there are other costs such as warehousing, transportation, etc. In fact, if you take a commodity (e.g., sugar) and look at the various deliveries, you will see that the price tends to rise (at least up to where there are enough volumes). So, if you subtract from the nearest delivery (with a lower price) the one furthest away (with a higher price), you will get a negative result, so below zero. So, if there are no anomalies, you have a contango with the spread having a negative price.

Conversely, if there is an anomaly, such as a drought or frost, what happens? The Commercial, those who have a direct interest in that commodity (e.g. because they use it in the production process, like sugar to make biscuits), for fear of not being able to get the normal supply in the future, buy more now. This leads to a lot of purchases in the first delivery(s), resulting in a price increase up to exceeding the most distant deliveries. So, the SBN23-SBV23 spread will have a positive price (above zero), due to the anomaly that led to more buying on the July delivery making it higher priced than the October delivery, and therefore in backwardation.

However, anyone can build a spread as he/she wishes. For example, Moore Research puts in the first leg the delivery to buy and in the second leg the delivery to sell. In fact, all spreads recommended by Moore Research are always to buy and never to sell. In this case, contango and backwardation depend on the spread. If the delivery to buy (first leg) is also the nearest one, then the case is the same as above with the sugar spread (above zero backwardation, below zero contango). If, on the other hand, the delivery to buy (first leg) is the furthest delivery, everything is reversed. In this case, if the price is above zero it is contango, below zero backwardation.

To conclude, I could have also just put the scheme below, but I preferred to explain all the situations well so that you understand this aspect.

Spread = leg 1 - leg 2

If leg 1 is the nearest delivery: price above zero backwardation, price below zero contango.

If leg 1 is the furthest delivery: price above zero contango, price below zero backwardation.