Backwardation occurs when the current price, or spot price, of an underlying asset is higher than the 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.
- This can result from higher current demand compared to the demand for future contracts maturing in the coming months.
- Traders capitalize on backwardation by selling short at the current price and purchasing at the lower futures price.
The Dynamics of Backwardation
The slope of the futures prices curve is an important sentiment indicator. The expected price of the underlying asset always fluctuates, influenced by factors such as fundamentals, trading positions, and supply and demand.
The spot price is the current market price at which an asset can be bought or sold. It is constantly changing due to the forces of supply and demand.
When a futures contract is priced lower than today’s spot price, it indicates that the current price is considered too high and the spot price is expected to fall in the future. This situation is referred to as backwardation.
For example, if futures contracts hold lower prices than the spot price, traders can profit by selling the asset at its spot price and buying the futures contracts. This drives the expected spot price lower over time until it converges with the futures price.
Hence, backwardation signals to traders and investors that the current price might be inflated and likely to drop as the futures contracts approach their expiration dates.
How Backwardation Occurs
Backwardation arises from various factors, including higher demand for the asset currently compared to future delivery dates. A primary cause in the commodities futures market is a spot market shortage. For instance, manipulation of supply, especially in markets like crude oil, can create such scenarios.
Net long investors benefit from the upward trend in futures prices over time as they converge with the spot price. For speculators and short-term traders, a backwardated market offers arbitrage opportunities.
However, risks persist. Investors may incur losses if futures prices continue to fall or if market conditions shift due to events like additional supplies coming online, affecting commodity shortages.
Basics of Futures Contracts
Futures contracts are binding agreements obliging a buyer to purchase, and a seller to sell, an asset at a set future date and price. For example, a December futures contract would settle in December. These contracts enable investors to lock in a price, benefiting from delivery or offsetting the contract before maturity through trading.
Pros
- Allows speculators and short-term traders to gain from arbitrage.
- Acts as a leading indicator showing expected decline in future spot prices.
Cons
- Possible losses if futures prices fall continuously.
- Trading based on an anticipated shortage can lead to losses if production increases and alters supply and demand dynamics.
Backwardation vs. Contango
When the prices are higher at each successive maturity date, it implies an upward sloping forward curve, or contango, which is the opposite of backwardation. In normal market conditions, futures contract prices tend to increase the further into the future they mature due to costs like carrying or storage costs.
In contango, higher future prices reflect the expectation that spot prices will rise to meet futures prices. Traders often short these higher-priced futures and buy at the lower spot prices, driving eventual price convergence.
Markets can oscillate between contango and backwardation over varying periods.
Backwardation in Action
Imagine a situation where West Texas Intermediate crude oil production plummets due to bad weather. The decline in supply raises the spot price to $150 per barrel. However, traders anticipate this is a temporary issue, keeping year-end futures prices around $90 per barrel. This indicates a backwardated market.
As the production eventually normalizes, increased output pushes down the spot price, aligning it with the futures prices as weather conditions improve. This illustrates backwardation’s market dynamics and resolution.
Related Terms: Contango, Futures Contract, Spot Price, Arbitrage, Short Selling, Commodities, Market Manipulation
