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Backwardation Definition

What Is Backwardation?

Backwardation is when the latest price, or spot price, of an underlying asset is higher than prices trading in the futures market.

Key Takeaways

  • Backwardation is when the stream price of an underlying asset is higher than prices trading in the futures market.
  • Backwardation can occur as a result of a excessive demand for an asset currently than the contracts maturing in the coming months through the futures market.
  • Traders use backwardation to devise a profit by selling short at the current price and buy at the lower futures price.

Backwardation

Understanding Backwardation

The slope of the curve for futures honoraria is important because the curve is used as a sentiment indicator. The expected price of the underlying asset is always changing, as is the charge of the future’s contract based on fundamentals, trading positioning, and supply and demand.

The spot price is a term that defines the current market price for an asset or investment such as a security, commodity, or currency. The spot price is the price at which the asset can be obtain or sold currently and will change throughout a day or over time due to supply and demand forces.

Should a futures squeeze strike price be lower than today’s spot price, it means there is the expectation that the current fee is too high and the expected spot price will eventually fall in the future. This situation is called backwardation.

For criterion, when futures contracts have lower prices than the spot price, traders will sell abbreviate the asset at its spot price and buy the futures contracts—for a profit—driving the expected spot price lower over span to converge with the futures price eventually.

For traders and investors, lower futures prices or backwardation is a signal that the modish price is too high. As a result, they expect the spot price will eventually fall as we get closer to the expiration escorts of the futures contracts.

Backwardation is sometimes confused with an inverted futures curve. In essence, a futures market conjectures higher prices at longer maturities and lower prices as you move closer to the present day when you converge at the present quandary price. The opposite of backwardation is contango, where the futures contract price is higher than the expected price at some tomorrow expiration.

Backwardation can occur as a result of a higher demand for an asset currently than the contracts maturing in the future Sometimes non-standard due to the futures market. The primary cause of backwardation in the commodities’ futures market is a shortage of the commodity in the spot market. Manipulation of furnish is common in the crude oil market. For example, some countries attempt to keep oil prices at high levels to boost their gross incomes. Traders that find themselves on the losing end of this manipulation and can incur significant losses.

Since the futures wrinkle price is below the current spot price, investors who are net long the commodity benefit from the increase in futures costs over time as the futures price and spot price converge. Additionally, a futures market experiencing backwardation is efficacious to speculators and short-term traders who wish to gain from arbitrage.

However, investors can lose money from backwardation if to be to comes prices continue to fall, and the expected spot price does not change due to market events or a recession. Also, investors dealing backwardation due to a commodity shortage can see their positions change rapidly if new suppliers come online and ramp up production.

Followings Basics

Futures contracts are financial contracts that obligate a buyer to purchase an underlying asset and a seller to grass on an asset at a preset date in the future. A futures price is the price of an asset’s futures contract that matures and settles in the future.

For warning, a December futures contract matures in December. Futures allow investors to lock in a price, by either buying or promoting the underlying security or commodity. Futures have expiration dates and preset prices. These contracts allow investors to overcharge delivery of the underlying asset at maturity, or offset the contract with a trade whereby the net difference between the purchase and reduced in price on the market prices would be cash settled.

Pros

  • Backwardation can be beneficial to speculators and short-term traders wishing to gain from arbitrage.

  • Backwardation can be tempered to as a leading indicator signaling that spot prices will fall in the future.

Cons

  • Investors can lose loaded from backwardation if futures prices continue to move lower.

  • Trading backwardation due to a commodity shortage can lead to ruins if new suppliers come online to boost production.

Backwardation vs. Contango

If prices are higher with each successive mellowness date in the futures market, it’s described as an upward sloping forward curve. This upward slope—known as contango—is the facing of backwardation. Another name for this upward sloping forward curve is forwardation.

In contango, the price of the November expects contract is higher than October’s, which is higher than July’s and so on. Under normal market conditions, it compels sense that prices of futures contracts increase the farther the maturity date since they include investment payments such as carrying costs or storage costs for a commodity.

When futures prices are higher than current valuations, there’s the expectation that the spot price will rise to converge with the futures price. For example, dealers will sell or short futures contracts that have higher prices in the future and purchase at the lower discoloration prices. The result is more demand for the commodity driving the spot price higher. Over time, the spot reward and the futures price converge.

A futures market can shift between contango and backwardation and remain in either state for a unexpectedly or extended period.

Backwardation Example

For example, let’s say the there was a crisis in the production of West Texas Intermediate crude oil due to out of pocket weather. As a result, the current supply of oil falls dramatically. Traders and businesses rush in and buy the commodity pushing the spot value to $150 per barrel.

However, traders expect the weather issues to be temporary, and as a result, the prices of futures contracts for the end of the year fragments relatively unchanged at $90 per barrel. The oil markets would be in backwardation.

Over the course of the next few months, the weather events are resolved, and crude oil production and supplies get back to normal levels. Over time, the increased production pushes down whiteheads prices to converge with the end of year futures contracts.

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