Why backwardation futures

Futures and forward curves. Contango from trader perspective. Severe contango generally bearish. Backwardation bullish or bearish. Contango and backwardation review. Upper bound on forward settlement price. Lower bound on forward settlement price. Arbitraging futures contract. Arbitraging futures contracts II. Futures fair value in the pre-market. Interpreting futures fair value in the premarket.

Contango and normal backwardation refer to the pattern of prices over time, specifically if the price of the contract is rising or falling. A contango market is often confused with a normal futures curve. A normal backwardation market—sometimes called simply backwardation—is confused with an inverted futures curve.

To better understand the difference between the two, start with a static picture of a futures curve. A static picture of the futures curve plots futures prices y-axis against contract maturities i. This is analogous to a plot of the term structure of interest rates.

We are looking at prices for many different maturities as they extend into the horizon. The chart below plots a normal market in green and an inverted market in red:. Your long position is not an option in the future, it is an obligation in the future. The red line in Figure 1, on the other hand, depicts an inverted market.

In an inverted market, the futures price for faraway deliveries is less than the spot price. If we really want to be precise, we could say fundamentals like storage cost, financing the cost—the cost to carry —and convenience yield inform supply and demand. Supply meets demand where market participants are willing to agree about the expected future spot price. Their consensus view sets the futures price.

And that's why a futures price changes over time: Market participants update their views about the future expected spot price. The traditional crude oil futures curve, for example, is typically humped: it is normal in the short-term but gives way to an inverted market for longer maturities. In the case of a physical asset, there may be some benefit to owning the asset called the convenience yield.

In the case of a financial asset, ownership may confer a dividend to the owner. At times it may be profitable to hold the tangible commodity rather than holding derivative products in the asset.

A futures market is normal if futures prices are higher at longer maturities and inverted if futures prices are lower at distant maturities. Upper bound on forward settlement price. Lower bound on forward settlement price. Arbitraging futures contract. Arbitraging futures contracts II. Futures fair value in the pre-market. Interpreting futures fair value in the premarket. Next lesson. Current timeTotal duration Google Classroom Facebook Twitter.

Video transcript If a commodities trader tells you that a market is in backwardation, they're essentially saying that it costs more to buy whatever commodity they're talking about now than it would to buy it later, to go into a futures contract to buy whatever that commodity might be-- silver, gold, or oil-- to buy it later.

So later is cheaper. So, the question you might ask yourself, or really, any trader might ask themselves, is this bullish or is this a bearish? 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 commodity.

When futures prices are higher than current prices, there's the expectation that the spot price will rise to converge with the futures price. For example, traders will sell or short futures contracts that have higher prices in the future and purchase at the lower spot prices. The result is more demand for the commodity driving the spot price higher. Over time, the spot price and the futures price converge. A futures market can shift between contango and backwardation and remain in either state for a short or extended period.

For example, let's say the there was a crisis in the production of West Texas Intermediate crude oil due to poor weather. As a result, the current supply of oil falls dramatically. However, traders expect the weather issues to be temporary. The oil markets would be in backwardation. Over the course of the next few months, the weather issues are resolved, and crude oil production and supplies get back to normal levels.

Over time, the increased production pushes down spot prices to converge with the end-of-year futures contracts. Trading Basic Education. Your Privacy Rights.

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