What Is Front Month?
Front month, also called "near" or "spot" month, refers to the nearest expiration date for a futures or options contract. Contracts that have later expiration dates than front month contracts are called back month, or "far month," contracts.
- Front months, also called "near" or "spot" months, refer to the nearest expiration date for futures or options contracts.
- Front months are typically the most heavily traded and most liquid options and futures contracts.
- The spread between the underlying security's front month futures price and its spot price will usually narrow until converging at expiration.
Understanding Front Month
Front month contracts have an expiration date that is closest to the current date. As a result, they tend to be the most heavily traded and the most liquid options and futures contracts for a given series or issue. Typically, but not always, the listed front month will be in the same calendar month. Front month prices are normally the ones used when quoting that security's futures price.
The spread between the underlying security's front month futures price and spot price will usually be the narrowest and will continue to shrink until they converge at expiration. Use of front month contracts requires an increased level of care, since the delivery date may lapse shortly after purchase, requiring the buyer or seller to actually receive or deliver the contracted commodity. Front month contracts are often paired with back month contracts to create calendar spreads.
Futures contracts have different expiration months throughout the year and many extend into the next year. Each futures market has its own specific expiration sequence. For example, financial instruments, such as Standard & Poor's (S&P) 500 E-mini futures or U.S. Treasury bond futures, use the quarterly expiration months of March, June, September, and December (contract month coded — H, M, U, & Z). Commodities markets are loosely tied to their mining, harvest, or planting cycles, and may have five or more delivery months in one year, and energy futures, such as crude oil, have monthly expiration dates as far into the future as nine years.
It is important to note that expiration dates and the last day of trading dates are not the same. For energy especially, contracts stop trading in the month prior to the expiration month. Therefore, selecting the proper expiration month for a trading strategy is quite important.
Backwardation and Contango
Backwardation and contango are terms that are used to describe the shape of a commodity's futures curve. Backwardation is when a commodity's futures price is lower for each successive month along the curve, resulting in an inverted futures curve. The futures spot price, which is the front month price, will be higher than the next month's price and so on. This is usually the result of some disruption to the current supply of that commodity. In other words, backwardation is when a commodity's current price is higher than its expected future price.
Contango refers to a normal futures curve for a commodity where its futures price is higher for each successive month along the curve. The spot price is lower than the next month's price and so on. This makes sense intuitively given that physical commodities will incur costs for storage, financing, and insurance. The longer out until expiration, the higher the costs. Simply put, contango is when a commodity's future price is expected to be more expensive than the spot price.
Both states of the market are important to know for futures strategies that involve rolling over positions as they near their respective expiration dates.
Front Month Example
A day trader in crude oil futures might purchase a futures contract, agreeing to purchase 1,000 barrels of oil for $62 per barrel with the front month being July. This means the contract expires in July, and that there is no earlier contract available.
If the trader still holds the contract at its expiration, they will need to take possession of 1,000 barrels of crude oil. The trader will take advantage of market volatility in the days leading up to the expiry date and attempt to make a profit on their right to the barrels of oil before the contract expires.