Define Backwardation

Backwardation

What Is Backwardation and How Does It Affect You?

Backwardation occurs when an underlying asset's current price, or spot price, is greater than futures market pricing.

TAKEAWAYS IMPORTANT

When the current price of an underlying asset is greater than the prices trading in the futures market, this is known as backwardation.

Backwardation can occur when there is now more demand for an asset than there are contracts expiring in the futures market in the coming months.

Traders profit from backwardation by selling short at present prices and purchasing at lower futures prices.

Backwardation: An Overview

The slope of the futures price curve is significant since it is utilized as a mood indicator. The predicted price of the underlying asset, as well as the price of the futures contract, is always changing according to fundamentals, trading positioning, and supply and demand.

The current market price for an item or investment, such as a securities, commodity, or currency, is referred to as the spot price. The spot price is the current price at which an item may be purchased or sold, and it fluctuates during the day or over time owing to supply and demand pressures.

If the striking price of a futures contract is lower than the current spot price, it indicates that the present price is too high and that the predicted spot price will decline in the future. Backwardation is the term for this condition.

Traders will short sell the asset at its spot price and buy the futures contracts for a profit, for example, when futures contracts have lower values than the current price. This lowers the projected spot price over time, finally bringing it in line with the futures price.

Lower futures prices, often known as backwardation, are a warning that the present price is too expensive for traders and investors. As a result, they believe the spot price will eventually decline as the futures contracts' expiration dates near.

In certain cases, backwardation is mistaken for an inverted futures curve. In principle, a futures market anticipates higher prices for longer maturities and lower prices as you get closer to the current day, when you converge at the current spot price. Contango is the inverse of backwardation, when the price of a futures contract is greater than the projected price at some future expiry.

Backwardation can occur when there is now more demand for an asset than there are contracts expiring in the futures market. A shortfall of the commodity on the spot market is the major cause of backwardation in the commodities futures market. In the crude oil market, supply manipulation is prevalent. Some governments, for example, want to maintain oil prices high in order to increase their revenue. Traders who lose money as a result of this manipulation may suffer large losses.

Because the futures contract price is lower than the current spot price, investors who are net long on the commodity gain from futures price increases when the futures and spot prices converge over time. Backwardation in the futures market is also advantageous to speculators and short-term traders looking to profit from arbitrage.

Backwardation, on the other hand, can cause investors to lose money if futures prices continue to decline while the projected spot price remains unchanged owing to market events or a recession. Also, if new suppliers come online and ramp up production, investors trading backwardation owing to a commodities scarcity may see their holdings shift quickly.

Futures Fundamentals

Futures contracts are financial arrangements in which a buyer is obligated to buy an underlying asset and a seller is obligated to sell an asset at a future date. The price of a futures contract on an asset that matures and settles in the future is known as a futures price.

A December futures contract, for example, expires in December. By purchasing or selling the underlying investment or commodity, futures allow investors to lock in a price. Futures have defined pricing and expiration dates. Investors can accept delivery of the underlying asset at maturity or offset the contract with a transaction with these contracts. The difference between buy and selling prices would be paid in cash.

Pros 

• Speculators and short-term traders looking to profit from arbitrage can benefit from backwardation.

• Backwardation can be used as a leading indicator to predict future spot price declines.

Cons

• Backwardation can cause investors to lose money if futures prices continue to fall.

• If new suppliers come online to augment supply, trading backwardation due to a commodities scarcity might result in losses.

Contango vs. Backwardation

In the futures market, an upward sloping forward curve is defined as prices rising with each consecutive maturity date. Contango is the inverse of backwardation, which is an uphill slope. Forwardation is another term for this steeply sloping forward curve.

In contango, the November futures contract is more expensive than October's, which is more expensive than July's, and so on. Because futures contracts involve investment expenditures such as transportation costs or storage costs for a commodity, it makes sense that prices of futures contracts rise as the maturity date approaches.

When futures prices are higher than current prices, the spot price is expected to climb to catch up with the futures price. Traders will, for example, sell or short futures contracts with higher future prices and buy at lower spot prices. As a result, there is greater demand for the product, which drives up the spot price. The spot price and the futures price converge over time.

A futures market can go back and forth between contango and backwardation and stay in either position for a short or long time.

Example of Backwardation

Let's imagine there was a production issue in West Texas Intermediate crude oil as a result of bad weather. As a result, the present oil supply is drastically reduced. Traders and corporations rush in to purchase the oil, driving the current price up to $150 per barrel.

Traders, on the other hand, believe the weather problems are just transitory. As a result, the prices of end-of-year futures contracts have remained essentially steady, around $90 per barrel. Oil markets would be in a state of backwardation.

The weather difficulties will be remedied during the following several months, and crude oil output and supply will return to normal levels. As supply rises, spot prices fall, bringing them closer to end-of-year futures contracts.