Backwardation is a market condition in which the spot or current price of an underlying asset exceeds the trading prices of the futures market. It is used by traders to generate profits by selling short at the current price and purchasing at a diminished futures price. In this article, we will understand what backwardation means in detail, its pros and cons, and how it compares to contango.
Key takeaways
- Backwardation occurs when the current spot price of an asset surpasses its futures market prices, often due to higher demand for the asset in the present compared to contracts maturing later.
- Backwardation often arises in commodity markets experiencing shortages. It reflects market sentiment, with futures prices generally increasing as maturity approaches, eventually converging with the spot price.
- Backwardation features a downward-sloping futures curve, indicating lower futures prices compared to current spot prices.
Understanding backwardation
The curve of the futures prices is used to indicate market sentiment, which makes the slope of the curve significant. The underlying asset’s anticipated price always fluctuates along with the future contract’s price, depending on trading positions, fundamentals, and demand and supply forces.
The current market price of an investment, like a security, currency, or commodity, is known as a spot price. At this price, the asset can be purchased or sold. Moreover, it changes throughout the day or over a period owing to demand and supply chains.
If a futures contract price is lower than today’s spot price, it implies that there is an anticipation that the current price is significantly higher and the spot price is expected to decline in the future. This scenario is known as backwardation. For instance, when future contracts exhibit lower prices compared to spot prices, traders will short-sell the asset at its spot price and purchase future contracts to make gains. This causes the expected spot price to fall eventually until it ends up merging with the futures prices.
Futures basics
Backwardation or lower futures prices serve as indicators to traders that the current price is considerably high. So, they expect that the spot price will drop over time as the expiry dates of the futures contracts come closer.
At times, backwardation can be confused with inverted futures curves. Basically, a futures market anticipates high prices at longer maturities and low prices as the present day approaches, where the current spot price converges. A contango is the opposite of backwardation, where the futures contract price surpasses the expected price at certain future expiry.
Backwardation occurs because there is an increased demand for security presently compared to the contracts, which will mature in future via the futures market. Mainly, backwardation occurs in the commodities’ futures market when there is a shortage of commodities in spot markets.
Backwardation example
Supply manipulation is commonly observed in the crude oil market. Certain economies try to maintain high oil prices to increase their revenue. Traders who bear the brunt of such manipulation, therefore, experience significant losses.
Investors with a long position in the commodity gain from the increase in futures prices over time when the futures price is lower than the spot price. This happens when the spot price and futures price converge. In addition, a futures market facing backwardation is advantageous to short-term traders and speculators who desire to make profits off arbitrage. However, investors can lose funds in backwardation if futures prices sustain their declining trend and the predicted spot price doesn’t alter because of recession or other market trends. Also, those using backwardation to trade because of commodity shortage can witness their positions changing instantly when new suppliers come on board and increase production.
What are the pros of backwardation?
- It benefits short-term traders and speculators planning to use arbitrage to make gains.
- It can be employed as an indicator to check for falls in spot prices in the future.
What are the cons of backwardation?
- If futures prices keep moving lower, investors will likely lose money with backwardation.
- If new suppliers come on board to amplify production, trading backwardation due to the shortage of commodities can trigger losses.
What is contango and what makes it different from backwardation?
If prices keep soaring after each consecutive maturity date in the futures market, it is known as an upward-sloping forward curve. Here, the upward slope is referred to as a contango, which is the opposite of backwardation. It is also known as ‘forwardation’.
When the futures prices exceed the current ones, there is a market anticipation that the spot price will adequately soar to coverage with the futures prices. For instance, traders will sell or short futures contracts having inflated prices in the future but at decreased spot prices. The outcome is more demand for the commodity, which propels the spot price levels. As time passes, the future price and spot price converge. A futures market is observed to sway between backwardation and contango and stay on either side for a brief or prolonged period.
Closing thoughts
When the present value of a security exceeds the futures market prices, it signals a backwardation condition. It may arise when there is increased interest in an asset than the contracts approaching maturity in the futures market. This situation is employed by traders to make gains by selling short at current prices and purchasing at lower futures prices.
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