What Is Backwardation?
Backwardation is when the current price, or spot price, of an underlying asset is higher than prices trading in the futures market.
Key Takeaways
- Backwardation is when the current price of an underlying asset is higher than prices trading in the futures market.
- Backwardation can occur as a result of a higher demand for an asset currently than the contracts maturing in the coming months through the futures market.
- Traders use backwardation to make a profit by selling short at the current price and buying at the lower futures price.
Understanding Backwardation
The slope of the curve for futures prices is important because the curve is used as a sentiment indicator. The expected price of the underlying asset is always changing, in addition to the price of the future's contract, based on fundamentals, trading positioning, and supply and demand.
Thespot price is a term that describes thecurrent market pricefor an asset or investment, such as a security, commodity, or a currency. The spot price is the price at which the asset can be bought or soldcurrently and will change throughout a day or over time due to supply and demand forces.
Should a futures contract strike price be lower than today's spot price, it means there is the expectation that the current price is too high and the expected spot price will eventually fall in the future. This situation is called backwardation.
For example, when futures contracts have lower prices than the spot price, traders will sell short the asset at its spot price and buy the futures contracts for a profit. This drives the expected spot price lower over time until it eventually converges with the futures price.
For traders and investors, lower futures prices or backwardation is a signal that the current price is too high. As a result, they expect the spot price will eventually fall as the expiration dates of the futures contracts approaches.
Backwardation is sometimes confused with an inverted futures curve. In essence, a futures market expects higher prices at longer maturities and lower prices as you move closer to the present day when you converge at the present spot price. The opposite of backwardation is contango, where the futures contract price is higher than the expected price at some future expiration.
Backwardation can occur as a result of a higher demand for an asset currently than the contracts maturing in the future through 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 supply is common in the crude oil market. For example, some countries attempt to keep oil prices at high levels to boost their revenues. Traders that find themselves on the losing end of this manipulation and can incur significant losses.
Since the futures contract price is below the current spot price, investors who are net long on the commodity benefit from the increase in futures prices over time, as the futures price and spot price converge. Additionally, a futures market experiencing backwardation is beneficial to speculators and short-term traders who wish to gain from arbitrage.
However, investors can lose money from backwardation if futures prices continue to fall, and the expected spot price does not change due to market events or a recession. Also, investors trading backwardation due to a commodity shortage can see their positions change rapidly if new suppliers come online and ramp up production.
Futures Basics
Futures contracts are financial contracts that obligate a buyer to purchase an underlying asset and a seller to sell 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 example, a December futures contract matures in December. Futures allow investors to lock in a price, by either buying or selling the underlying security or commodity. Futures have expiration dates and preset prices.These contracts allow investors to take delivery of the underlying asset at maturity, or offset the contract with a trade. The net difference between the purchase and sale prices would be cash settled.
Pros
Backwardation can be beneficial to speculators and short-term traders wishing to gain from arbitrage.
Backwardation can be used as a leading indicator signaling that spot prices will fall in the future.
Cons
Investors can lose money from backwardation if futures prices continue to move lower.
Trading backwardation due to a commodity shortage can lead to losses if new suppliers come online to boost production.
Backwardation vs. Contango
If prices are higher with each successive maturity date in the futures market, it's described as an upward sloping forward curve. This upward slope—known as contango—is the opposite of backwardation. Another name for this upward sloping forward curve is forwardation.
In contango, the price of the November futures contract is higher than October's, which is higher than July's and so on. Under normal market conditions, it makes sense that prices of futures contracts increase the farther the maturity date since they include investment costs such as carrying costs or storage costs for a commodity.
When futures prices are higher than current prices, there's the expectation that the spot price will rise to converge with the futures price. For example, traders will sell or short futures contracts that have higher prices in the future and purchase at the lower spot prices. The result is more demand for the commodity driving the spot price higher. Over time, the spot price and the futures price converge.
A futures market can shift between contango and backwardation and remain in either state fora short 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 poor weather. As a result, the current supply of oil falls dramatically. Traders and businesses rush in and buy the oil, which pushes the spot price to $150 per barrel.
However, traders expect the weather issues to be temporary. As a result, the prices of futures contracts for the end of the year remain relatively unchanged, at $90 per barrel. The oil markets would be in backwardation.
Over the course of the next few months, the weather issues are resolved, and crude oil production and supplies get back to normal levels. Over time, the increased production pushes down spot prices to converge with the end-of-year futures contracts.
