RE: Backwadation3 Jan 2024 12:05
Backwardation can occur as a result of a higher demand for an asset currently than the contracts maturing in the future through the futures market. The primary cause of backwardation in the commodities' futures market is a shortage of the commodity in the spot market. Manipulation of supply is common in the crude oil market. For example, some countries attempt to keep oil prices at high levels to boost their revenues. Traders that find themselves on the losing end of this manipulation and can incur significant losses.
Since the futures contract price is below the current spot price, investors who are net long on the commodity benefit from the increase in futures prices over time, as the futures price and spot price converge. Additionally, a futures market experiencing backwardation is beneficial to speculators and short-term traders who wish to gain from arbitrage.
However, investors can lose money from backwardation if futures prices continue to fall, and the expected spot price does not change due to market events or a recession. Also, investors trading backwardation due to a commodity shortage can see their positions change rapidly if new suppliers come online and ramp up production.
Futures Basics
Futures contracts are financial contracts that obligate a buyer to purchase an underlying asset and a seller to sell an asset at a preset date in the future. A futures price is the price of an asset's futures contract that matures and settles in the future.
For example, a December futures contract matures in December. Futures allow investors to lock in a price, by either buying or selling the underlying security or commodity. Futures have expiration dates and preset prices. These contracts allow investors to take delivery of the underlying asset at maturity, or offset the contract with a trade. The net difference between the purchase and sale prices would be cash settled.
Pros
Backwardation can be beneficial to speculators and short-term traders wishing to gain from arbitrage.
Backwardation can be used as a leading indicator signaling that spot prices will fall in the future.
Cons
Investors can lose money from backwardation if futures prices continue to move lower.
Trading backwardation due to a commodity shortage can lead to losses if new suppliers come online to boost production.
Backwardation vs. Contango
If prices are higher with each successive maturity date in the futures market, it's described as an upward sloping forward curve. This upward slope—known as contango—is the opposite of backwardation. Another name for this upward sloping forward curve is forwardation.
In contango, the price of the November futures contract is higher than October's, which is higher than July's and so on. Under normal market conditions, it makes sense that prices of futures contracts increase the farther the maturity date since they include investment costs such as carrying costs or storage costs for a com
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