Backwardation - Explained
What is Backwardation?
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Table of ContentsWhat is Backwardation?How Does Backwardation Work?Academic Research on Backwardation
What is Backwardation?
This relates to the price of a futures contract as it nears expiration. A futures contract usually trades at a higher price when it nears expiration than when it is further away. This is as a result of the spot price being above the futures price and since these to have to merge eventually, the future's price increases to match with the spot price.
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How Does Backwardation Work?
Since the futures prices keep rising towards the spot price, backwardation favors the ones who are net long. The expected future spot price keeps changing the same as the future contracts price. This happens as a result of trade positioning, fundamentals as well as supply and demand of the underlying asset. The opposite of backwardation is contango which is when an underlying security's futures price rises above the expected spot price. A contango is used to indicate that the futures prices reduce over time to converge with the future spot price. For example, if the futures contracts on crude oil slated for delivery in six months are trading at $50 per barrel, and their expected spot price is $40 per barrel, the market is then said to be in contango. A shortage of commodity in the spot market is one of the significant causes of backwardation in the commodities futures market. The investors who are net long benefit from the gradual rise of futures prices as they converge with the spot price. Backwardation in the futures market also benefit the speculators and short-term traders who are looking to gain from arbitrage. If the futures and the spot price don't converge, a riskless profit can be made between the two. However, as investors try to exploit this opportunity, they end up driving these two prices together. A futures market usually shifts between contango and backwardation and may stay in one of these states for small or extended periods. For example, upon the temporary shutdown of a natural gas refinery, spot prices could be driven up while the futures further from expiry would remain stable below the current spot price since the shutdown does not affect the long-term outlook. This is contango. Also, a harsh growing season may result in an agricultural commodity entering backwardation. During harvesting future contract prices which are further away from expiry could be pushed up due to supply issues.