What Is Backwardation?
Let me explain backwardation directly to you: it's when the current price, or spot price, of an underlying asset stands higher than the prices trading in the futures market. This isn't some rare anomaly; it happens in commodities and other markets, and understanding it can give you an edge in trading.
Key Takeaways
Backwardation means the spot price exceeds futures prices, often stemming from stronger current demand than what's anticipated for future deliveries via contracts. You can use this to your advantage by shorting at the spot price and buying into lower futures for potential profits. Keep in mind, this setup reflects market sentiment where the futures curve slopes downward, indicating expectations of falling spot prices over time.
Understanding Backwardation
The futures price curve matters because it acts as a key indicator of market sentiment. I want you to know that both the expected spot price and futures contract prices fluctuate based on fundamentals, trading positions, and supply-demand dynamics. The spot price is simply the current market rate for immediate buying or selling of an asset, shifting daily with those forces.
If a futures contract's strike price dips below today's spot, it suggests the market views the current price as inflated, expecting it to drop later. That's backwardation in action. For instance, traders might short the asset at spot and buy futures to lock in gains, gradually pulling the spot price down toward convergence with futures.
As a trader or investor, you should see backwardation as a sign that spot prices are overvalued and poised to decline as contract expirations near. Don't confuse this with an inverted futures curve, though they're related; backwardation specifically involves spot exceeding near-term futures. The flip side is contango, where futures prices climb above expected future spots.
Backwardation often arises from immediate asset demand outstripping future contract supplies, especially in commodities. A classic cause is a spot market shortage, like manipulated oil supplies where countries prop up prices for revenue. If you're net long on the commodity, you benefit as futures rise to meet spot upon convergence. Speculators and short-term traders exploit this for arbitrage, but beware: if futures keep falling or new supply floods in, you could face losses.
Futures Basics
Futures contracts are straightforward obligations: they require buyers to purchase and sellers to sell an asset at a predetermined future date and price. The futures price is what that contract settles at upon maturity. Take a December contract—it expires in December, allowing you to lock in prices for securities or commodities.
These have fixed expiration dates and prices, so you can take delivery or offset by trading the net difference for cash settlement. In backwardation, this setup favors those betting on convergence.
Pros and Cons of Backwardation
- Backwardation offers arbitrage gains for speculators shorting spot and buying futures.
- It signals potential future spot price drops, aiding your market predictions.
- However, ongoing futures declines can lead to losses if spot doesn't adjust as expected.
- Positions based on shortages risk reversal if new production ramps up suddenly.
Backwardation vs. Contango
In contango, futures prices rise with later maturities, creating an upward curve—also called forwardation. This is normal, factoring in costs like storage. Here, you'd expect spot to rise toward futures, prompting shorts on high futures and buys at low spot to drive convergence.
Markets switch between backwardation and contango, sometimes staying in one for prolonged periods. You need to monitor these shifts for informed trading.
Backwardation Example
Consider a weather crisis hitting West Texas Intermediate crude oil production, slashing current supply. Traders and businesses buy up oil, spiking the spot price to $150 per barrel. But with the issue seen as temporary, year-end futures hold at $90 per barrel—classic backwardation.
As weather clears and production normalizes over months, increased supply drags spot down to align with those futures prices. This shows how backwardation resolves through market forces.
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