Backwardation: What Is It?

When an underlying asset’s spot or current price is more significant than those traded in the futures market, this is known as backwardation.

Recognizing Reverse

Since the curve is utilized as a sentiment indicator for futures prices, its slope matters. In addition to the contract price for the future, the underlying asset’s projected price constantly fluctuates according to supply and demand, trading positioning, and fundamentals.

The current market price of an investment or item, such as a currency, commodity, or security, is called the “spot price.” The present price at which an asset may be purchased or sold is known as the “spot price,” which is subject to vary during the day or over time due to supply and demand dynamics.

If the striking price of a futures contract is less than the spot price as of right now, it indicates that it is anticipated that the present price is excessive and that the predicted spot price will soon decline. We refer to this state as backwardation.

For instance, traders will sell the asset at its spot price and purchase the futures contracts at a profit if the prices of the futures contracts are lower than the spot price. As a result, the anticipated spot price gradually declines and finally converges with the futures price.

Lower futures prices or backwardation are indicators to traders and investors that the present price is excessively high. They thus anticipate that the spot price will finally decline as the expiration dates of futures contracts get closer.

Sometimes, backwardation is mistaken for an inverted futures curve. When you converge at the current spot price, a futures market essentially anticipates higher prices at longer maturities and lower prices as you get closer to the present. Contango, in which the price of the futures contract is greater than the anticipated price at a future expiry, is the reverse of backwardation.

If there is more demand for an asset right now than for the contracts that will mature through the futures market later, this can lead to backwardation. A scarcity of commodities on the spot market is the main reason for backwardation in the commodity futures market. In the crude oil market, supply manipulation is a typical occurrence. For instance, several nations want to maintain high oil prices to increase their revenue. It is possible for traders who lose out on this manipulation to suffer significant losses.

Investors that are net long on the commodity profit from the rise in futures prices over time as the futures price and spot price converge since the futures contract price is lower than the current spot price. Speculators and short-term traders looking to profit from arbitrage can also benefit from a backward futures market.

On the other hand, backwardation can cost investors money if futures prices keep down and the anticipated spot price remains constant despite market or recessionary developments. Furthermore, if new suppliers enter the market and increase output, investors trading backward due to a lack of commodities may find that their positions quickly shift.

Futures Foundations

Financial agreements known as futures contracts bind a seller to sell an asset at a predetermined future date and a buyer to acquire the underlying asset. The futures contract cost for an item that settles and matures in the future is known as its futures price.

A December futures contract, for instance, matures in December. With futures, investors may purchase or sell the underlying investment or commodity to lock in a price. Futures have predetermined pricing and expiration dates. Investors may offset the contract with a transaction or accept the delivery of the underlying asset at contract maturity. A cash settlement would be made for the net difference between the purchase and selling prices.

Pros

• Speculators and short-term traders looking to profit from arbitrage may find backwardation advantageous.
• One useful leading indicator that suggests future declines in market prices is backwardation.

Cons

• If future prices continue to decline, investors may experience a loss due to backwardation.
• If new suppliers enter the market to increase output, trading backwardation brought on by commodity scarcity may result in losses.

Contango vs. Backwardation

In the futures market, a price curve that slopes upward toward future maturity dates is called an upward-sloping forward curve. Backwardation is the reverse of the contango, which is an upward slope. Forwardation is another term for this upward-sloping forward curve.

A contango occurs when the price of a futures contract in November is higher than that of October, which is higher than that of July, and so on. Since futures contracts involve investment expenditures like transportation or storage fees for commodities, it seems natural that their values will rise as the maturity date approaches under typical market circumstances.

It is anticipated that the spot price will increase to converge with the futures price when futures prices are higher than current pricing. For instance, traders will buy at lower spot prices and sell short-term contracts with higher future values. As a result, the commodity is in more demand, which raises the spot price. The market price and the futures price converge with time.

Futures markets can fluctuate between contango and backwardation, and they can stay in either position for a brief or long time.

Example of Backwardation

For example, bad weather caused a problem in West Texas Intermediate crude oil output. The present oil supply consequently declines significantly. Companies and traders buy the oil, raising the current price to $150 per barrel.

Traders anticipate that the weather problems will pass quickly, though. Consequently, futures contract prices for the year-end remain primarily steady at $90 per barrel. There would be a backwardation in the oil markets.

The weather problems are fixed over the following few months and the supply and output of crude oil return to normal. The higher output gradually drives down spot prices until they align with the end-of-year futures contracts.

Conclusion

• When an underlying asset’s current price exceeds what is being traded in the futures market, this is known as backwardation.
• When there is more demand for an asset right now than for the contracts that will mature in the futures market in the upcoming months, backwardation may emerge.
• Traders can benefit from backwardation by selling short at the present price and purchasing at the lower futures price.