Basis and Contango/Backwardation
What is Basis
Basis is the difference between the futures price and the spot price.
Basis = Futures Price - Spot Price
- Positive Basis: Futures > Spot. Premium state
- Negative Basis: Futures < Spot. Discount state
In traditional finance, futures typically trade slightly higher than spot due to storage costs and interest rates. In cryptocurrency, basis can go either way depending on market sentiment.
Contango
Definition
Contango is a state where futures prices are higher than spot prices. Longer-dated futures have higher prices.
Spot < Near-month < Far-month
Causes of Contango
- Bullish Expectations: Market participants anticipate future price increases and pay a premium for futures
- Cost of Carry: The cost of holding spot (storage, insurance, etc.) is reflected in the futures premium. This is minimal in cryptocurrency
- Leverage Demand: When there is high demand for leveraged long positions, futures prices rise
Contango and Market Sentiment
| Contango Level | Annualized Rate | Interpretation |
|---|---|---|
| 0-5% | Normal | Typical bullish sentiment |
| 5-15% | High | Strong upward expectations. Active leverage demand |
| 15-30% | Very High | Overheated. Historically observed near market tops |
| 30%+ | Extreme | Possible bubble. Strong correction warning |
Annualized calculation: Quarterly futures basis x 4, monthly basis x 12 (approximate)
Backwardation
Definition
Backwardation is a state where futures prices are lower than spot prices. Longer-dated futures have lower prices.
Spot > Near-month > Far-month
Causes of Backwardation
- Bearish Expectations: Market anticipates future price declines
- Hedging Demand: Spot holders sell futures to hedge against declines, pushing futures prices down
- Short Crowding: When short demand exceeds long demand, futures prices fall below spot
Backwardation and Market Sentiment
Backwardation is relatively rare in cryptocurrency, and when it occurs, it often indicates extreme fear.
- Mild Backwardation: Increased uncertainty. Market is watching
- Strong Backwardation: Extreme bearish sentiment. Panic. However, paradoxically may signal a bottom
Historically, when Bitcoin entered backwardation (March 2020, FTX collapse in 2022), it was usually near market bottoms.
Perpetual Futures and Basis
Perpetual futures have no expiration, so instead of traditional basis, the funding rate adjusts the divergence from spot.
However, premiums/discounts still exist in perpetual futures.
| Perpetual Futures State | Basis Concept | Funding Rate |
|---|---|---|
| Premium (Futures > Spot) | Similar to Contango | Positive (Longs pay Shorts) |
| Discount (Futures < Spot) | Similar to Backwardation | Negative (Shorts pay Longs) |
When perpetual futures premiums align with dated futures contango, the entire market has reached a bullish (or bearish) consensus.
Term Structure
Concept
Term structure is the curve connecting futures prices across different maturities. It shows prices from near-term to long-term expirations at a glance.
Interpretation by Shape
Normal Contango Curve:
- Gentle upward slope with higher prices for distant maturities
- Normal market condition
Steep Contango Curve:
- Very high premiums for far-dated contracts
- Market expects strong medium to long-term gains
Flat Curve:
- Minimal price differences between maturities
- Uncertain direction. Market is waiting
Backwardation Curve:
- Prices decline with longer maturities
- Current anxiety exceeds future concerns. Or extreme bearishness
Inversion:
- A specific maturity has abnormally high or low prices
- Occurs when special events (halving, ETF decisions, etc.) are expected at that time
Basis Trading
Cash and Carry
A strategy of simultaneously buying spot and selling futures in contango conditions.
- Buy spot BTC
- Sell the same amount of BTC futures
- At expiration, futures converge with spot
- Profit equals the basis (premium)
Example: Spot $100,000, 3-month futures $105,000 (5% premium)
- Buy spot + Sell futures
- Convergence after 3 months: ~5% profit (annualized ~20%)
Reverse Cash and Carry
A strategy of selling spot (short selling) and buying futures in backwardation. Execution is limited in cryptocurrency since spot short selling is difficult.
Risk Factors
- Basis Expansion: If basis widens after entry, unrealized losses occur
- Margin Risk: Need to manage futures position margin
- Exchange Risk: Position loss if exchange fails or goes bankrupt
Basis and Market Cycles
Bull Market
- Contango continuously expands
- Term structure becomes steeply upward
- Overheating warning when annualized premiums reach 20-30%
Bear Market
- Contango narrows, flattens, then shifts to backwardation
- Term structure becomes flat or inverts
- Entry into backwardation signals extreme fear
Cycle Turning Points
The transition from contango to backwardation, or vice versa, indicates a fundamental shift in market sentiment. These turning points often coincide with major price reversals.
Combining with Other Indicators
Basis + Funding Rate
When dated futures basis and perpetual funding rate show extreme values in the same direction, market consensus is strong. When both are high, the overheating warning is reinforced.
Basis + Open Interest
When contango expands while open interest also increases, it signals strong inflow of leveraged long demand.
Basis + Fear & Greed
When the Fear & Greed Index shows extreme greed alongside high basis, both spot and derivatives markets are at peak sentiment.
Summary
Basis is the price difference between spot and futures, reflecting market expectations about the future. Contango (futures > spot) indicates bullish sentiment, while backwardation (futures < spot) indicates bearish sentiment. Extreme contango warns of overheating, while backwardation entry can signal extreme fear yet paradoxically mark a bottom. Observing the term structure reveals the temporal distribution of market sentiment, and the cash and carry strategy can monetize basis itself.
Next article: Futures Premium Analysis - What the Spot-Futures Price Gap Tells Us