What Is Front Month?
The term "front month" refers to the nearest expiration date in futures trading. It is commonly used when describing futures or options contracts with earlier expiration dates. Put simply, it is the shortest length of time for which the contract can be purchased. Contracts that fall into this category tend to be very heavily traded and are often very liquid because of the short expiry date. A front month is the opposite of a back month, which denotes expiration dates for contracts that are far off in the future.
Key Takeaways
- A front month is the nearest expiration date for a futures or options contract.
- The front month represents the shortest length of time for which the contract can be purchased
- Front months are typically the most heavily traded and most liquid options andfutures contracts.
- The spread between the underlying security's front month futures price and its spot price will usually narrow until converging at expiration.
- The opposite of a front month is the back month, which refers to a date further off in the future.
Understanding Front Month
Derivatives are financial contracts whose value is based on the price of an underlying asset. Both options and futures are two types of contracts. An options contract gives the investor the right but not the obligation to buy or sell the underlying asset at a specific price by a certain date. A futures contract, on the other hand, obligates the holder to buy or sell the asset on a specific date in the future.
A contract's expiration date refers to the time at which it matures. In some cases, contracts expire far off in the future. In other instances, they expire within a relatively shorter period of time. The expiration month in these latter contracts is called a front month.
These contracts tend to be the most heavily traded and the most liquidoptions and futures contracts for a given series or issue. Although it's not always the case, the listed front month is typically 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 its spot price is normally the narrowest and continues to shrink until they converge at expiration. The use of front-month contracts requires an increased level of care since the delivery date may lapse shortly after purchase. That's because it requires the buyer or seller to actually receive or deliver the contracted commodity.
The front month is also sometimes referred to as the near month or the spot month.
Special Considerations
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, and Z).
- Commodities markets are loosely tied to their mining, harvest, or planting cycles, and may have five or more delivery months in one year. Energy futures, such as crude oil, have monthly expiration dates as far into the future as ten 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 describe the shape of a commodity futures curve.
Backwardation occurs 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. Thelonger out untilexpiration, the higher the costs. Simply put, contango is when a commodity's futures price is expected to be more expensive than the spot price.
Both states of the market are important to know for futures trading strategies that involve rolling over positions as they near their respective expiration dates.
Front Month vs. Back Month
As noted above, contracts with front month expiration dates are those that come due in the shortest amount of time possible. These contracts are often paired with back-month contracts to create calendar spreads.
Back-month contracts have later expiration dates than front-month contracts and are also called far-month contracts. Unlike front-month contracts, prices for contracts that expire in back months have different prices. As such, they tend to be more expensive. That's because there is a lot more uncertainty associated with these contracts.
Back-month contracts are also less liquid than those with front-month expiration dates. Because of this, there is a lot less trading volume, which can add to the overall risk
Example of Front Month
Here's a hypothetical example to show demonstrate how a front-month contract works. Let's say a day trader in crude oil futures purchases a futures contract and agrees 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 there is no earlier contract available.
If the trader still holds thecontract 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.
