What is a front month and how does it work in the futures market with examples?

Summary

The front month in the futures market is the contract with the shortest time to expiration. It is the most liquid month, meaning it is the easiest to trade and has the lowest trading costs. In this blog, we will discuss what a front month is, how it works, and provide some examples for better understanding.

The futures market has an interesting story. It started long ago when ancient traders needed a way to manage the risks of their goods. Imagine agreeing to sell a batch of coffee beans in three months, but setting the price today. That's the basic idea.

By the time the 19th century rolled around, global trade was booming. So, there was a need for official establishments, called futures exchanges, where future trading could happen. As time went on, different types of contracts were created. One of these is the 'front month', and we are going to especially focus on it in this article.

What is a front month contract in the futures market?

The "front month contract" is the one with the nearest expiration date. It's usually the contract most traders choose because it has the most activity and the smallest difference between the buying and selling prices, known as the bid-ask spread. This makes the front month contract the top pick for traders who want to protect against price shifts or guess future prices. For example, if it's September 2023 and there are contracts ending in October and November, the October contract is the front month contract.

Front month vs. Back month: How are they different?

Now that we've discussed the front month, let's take a look at the back month. The term "back month" may suggest that we're talking about a month in the past, but it actually refers to the month with the furthest expiration date.

Here is a side-by-side comparison between the two:

Table 1: Front month vs. back month: A quick review

How does the front month work?

The front month contract is a critical player in the futures market because its expiration date is coming soon, and it sees a lot of trading. Let's take a closer look at how the front month works.

• Spot price

The spot price is the current price you'd pay for commodities like oil. It reflects market conditions and can change due to events like geopolitical shifts or changes in production.

• Trading dynamics

Suppose in October 2023, traders predict November oil prices. If they expect prices to rise, they will buy a front month contract to sell later at a profit. If they foresee a decline, they would sell now, and buy it back later at a favourable price.

• Settlement mechanisms

Traders sometimes use a rollover strategy near expiration. They close their current position and open a new one in a future contract, moving their trade to a later date.

• Rollover strategies

Traders sometimes use a rollover strategy near expiration. They close their current position and open a new one in a future contract, moving their trade to a later date.

• The next front month

After a contract expires, the following one becomes the new front month. So, if the October contract ends, November becomes the primary focus for traders.

Benefits of trading front month contracts

The appeal of front month contracts is not just their immediacy, but also the advantages they offer traders. Here are some of them:

• Lower costs: Often, the trading costs associated with front month contracts can be lower than those with longer-term agreements because they're traded more frequently.
• High liquidity: Front month contracts are popular among traders. This means there are many people buying and selling, making it easier to enter or exit a position without causing significant price changes.
• Quick profits: The short duration of these contracts can allow for quick gains, especially if a trader can accurately predict short-term market movements.
• Price transparency: Due to the high trading volume, the prices of front month contracts are a clear reflection of current market sentiments. This gives traders a clear view of the market's direction.

Risks of trading front month contracts

Some of the drawbacks and dangers of trading front month contracts are:

• Market manipulation: Due to the high volume of trades, front month contracts can sometimes be targets for market manipulation, where large traders or entities influence prices for their benefit.
• Price volatility: The prices of front month contracts can change rapidly. This means that while there's potential for quick profits, there's also a risk of swift losses.
• Potential for physical delivery: Some futures contracts, like those for commodities, might require physical delivery upon expiration. If a trader isn't prepared for this, it can result in unexpected challenges and costs.
• Rollover challenges: As the expiration date nears, traders need to decide whether to roll over to a new contract or settle the current one. This decision can be complex and might lead to additional costs.

Wrapping up: Key points to remember

• The futures market is where traders lock in prices for future delivery, covering everything from gold to wheat.
• Front month contracts, with the nearest expiry, often see more trading action and can be more volatile than back month contracts.
• While front month contracts offer benefits like high liquidity and the potential for quick profits, they also come with risks such as market manipulation and price volatility.

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