What does backwardation mean?
The underlying asset, price, and the futures market are three things that make the term backwardation. It refers to an underlying asset with a spot or current price, which is more than the trading price at the futures market. The futures price’s slope is crucial because the curve can tell us a lot about sentiments. We never can tell how the underlying asset’s price will accurately turn out in the end because it is dynamic. It can always change. The same is true with the futures contract price, which depends on fundamentals, trading positions, supply, and demand. Backwardation is considered the opposite of contango, where the futures contract price is more than the price expected in a specific expiration.
What is a spot price anyway?
Spot price means the current price of a specific asset or investment. For example, it can be currencies, commodities, securities, and the like. This price changes throughout the day because of supply and demand. Hence, it is the price at which one can buy or sell a particular asset. If the futures contract’s strike price is below the current spot price, many might have expected that the current price is too expensive, and the spot price should decline in the long run. This situation is a classic example of backwardation.
Let us cite an example.
Let us say that the futures contracts price is lower than the spot price. What do you think will the traders do in this situation? They can sell the asset short at the spot price then buy futures contracts to gain profits. This action will decline the spot price until it is in line with the futures price. In a nutshell, backwardation makes traders and investors think that the current price is too much. Hence, they expect the spot price to decline as the futures contracts expiration date gets nearer.
The confusion between backwardation and inverted futures curve
The futures markets think that the longer the maturity, the higher the prices. So, as the expiration gets nearer, the price becomes lower. Backwardation may happen when there is high demand for the asset at the moment than the contract’s future maturity in the futures market. It is the result of commodity shortages in the spot market. Furthermore, supply manipulation is not uncommon in the crude oil market. Some nations may try to keep their oil prices expensive when they want more revenues. Traders may feel like they will lose money and can’t take advantage of this situation.
And when the futures contract price is below the current spot price, investors who are long on the commodity can generate profits in the futures prices in the long run. And when we say in the long run, we refer to the time when the futures and spot price finally converge. A futures market in backwardation is suitable for speculators and day traders who take advantage of arbitrage. However, they should always be careful because they can also lose money if the futures price continuously declines.
Is backwardation a good thing?
It depends on every person. As we’ve said, backwardation may benefit speculators and short-term traders who want to profit from arbitrage. It can also be a sign that spot prices will decline in the long run. On the other hand, it can be a reason why one will lose money. The futures prices may not stop from slipping. People who trade backwardation because of commodity shortage can also have losses if the new suppliers opt to sell online for better production.