A:

Backwardation is a market condition in which a futures contract far from its delivery date is trading at a lower price than a contract closer to its delivery date. A “normal” futures curve shows increasing prices as time moves forward because the cost to carry the goods increases with long contract expirations (traders don’t want to deal with transport and storage costs). In backwardation this curve is inverted.

Investors look at futures backwardation as a sign that price deflation is on the horizon. Backwardation is most likely to occur when there is a short-term shortage of a particular commodity, specifically “soft” commodities like oil and gas, but less likely to occur in money commodities, such as gold or silver.

How can investors spot commodities that may have inverted futures curves? Look to the news. Backwardation is most likely to occur from short-term factors leading to fears of scarcity: extreme weather, wars, natural disasters, and political events. Examples of events include a hurricane threatening to knock out oil production, or disputed vote counts in an election in a country that produces natural gas.

One way to identify futures that are experiencing backwardation is to look at the spread between near month contracts and contracts that are further out. If a futures contract is trading below the spot price it will eventually increase because the price must eventually converge with the spot price upon contract expiration. Investors trading futures contracts in commodities considered to be in backwardation are most likely going to hold a long position.

Analyzing price spreads between contracts will not always give investors the most accurate view of what will happen with a futures contract, but in extreme cases, it can provide useful information that can guide further research. Markets can change quickly, and the state of the market when an investor takes a long futures position to take advantage of backwardation can shift to make that position unprofitable.

RELATED FAQS
  1. How can traders use contango to take advantage of the storage shortage for crude ...

    Learn how traders can profit in oil markets with a contango forward term structure by storing oil, and understand how other ... Read Answer >>
  2. Is backward integration the same thing as vertical integration?

    Learn if there are any differences between backward integration and vertical integration. Learn where on the production line ... Read Answer >>
  3. How can I calculate the notional value of a futures contract?

    Learn how the notional value of a futures contract is calculated, and how futures are different from stock since they have ... Read Answer >>
  4. Why do futures' prices converge upon spot prices during the delivery month?

    It's a fairly safe bet that as the delivery month of a futures contract approaches, the future's price will generally inch ... Read Answer >>
  5. What are the disadvantages of backward integration for a mid-sized business seeking ...

    Learn more about backward vertical integration and the disadvantages of this business strategy for some small and midsized ... Read Answer >>
  6. What types of items can you buy futures for?

    Learn what items futures may be purchased for, what a futures contract is and discover how the futures markets have greatly ... Read Answer >>
Related Articles
  1. Markets

    Contango Versus Normal Backwardation

    It’s important for both hedgers and speculators to know whether the commodity futures markets are in contango or normal backwardation.
  2. Trading

    The Difference Between Forwards and Futures

    Both forward and futures contracts allow investors to buy or sell an asset at a specific time and price.
  3. ETFs & Mutual Funds

    USO Vs. DBO: Comparing Oil ETFs

    Discover two major oil ETFs, The United States Oil Fund and The PowerShares DB Oil Fund, and the major differences between the two funds.
  4. Investing

    Options on Futures

    Options on futures contracts offer another way for day traders to use options. These are traded on the same exchange as the underlying futures contract. Traders should take care to understand ...
  5. ETFs & Mutual Funds

    Think Twice Before Buying A Top Oil ETF

    One of the hottest topics of debate among investors over the past six months has been when/if to invest in crashing crude oil. By far, the most popular oil ETF is the United States Oil Fund, ...
  6. Markets

    Investing in Crude Oil Futures: The Risks and Rewards

    Learn about the risks and rewards of trading oil futures contracts. Read about a few strategies to limit the risk in trading oil futures contracts.
  7. Markets

    What Does Contango Mean?

    Contango​ is when the futures price of a commodity is higher than the expected future spot price.
  8. ETFs & Mutual Funds

    Introduction To Currency Futures

    The forex market is not the only way for investors and traders to participate in foreign exchange.
  9. Trading

    Intermediate Guide To E-Mini Futures Contracts - Rollover Dates And Expiration

    A contract month is the month in which a futures contract expires. All of the e-mini stock index futures contracts trade on the March quarterly expiration cycle (March, June, September and December). ...
  10. Trading

    Futures Fundamentals: Strategies

    Essentially, futures contracts try to predict what the value of an index or commodity will be at some date in the future. Speculators in the futures market can use different strategies to take ...
RELATED TERMS
  1. Backwardation

    A theory developed in respect to the price of a futures contract ...
  2. Convergence

    The movement of the price of a futures contract towards the spot ...
  3. Contango

    A situation where the futures price of a commodity is above the ...
  4. Back Months

    The available futures contracts for a particular commodity that ...
  5. Futures Contract

    A contractual agreement, generally made on the trading floor ...
  6. Backward Integration

    A form of vertical integration that involves the purchase of ...
Hot Definitions
  1. Poison Pill

    A strategy used by corporations to discourage hostile takeovers. With a poison pill, the target company attempts to make ...
  2. Glass-Steagall Act

    An act the U.S. Congress passed in 1933 as the Banking Act, which prohibited commercial banks from participating in the investment ...
  3. Quantitative Trading

    Trading strategies based on quantitative analysis which rely on mathematical computations and number crunching to identify ...
  4. Bond Ladder

    A portfolio of fixed-income securities in which each security has a significantly different maturity date. The purpose of ...
  5. Duration

    A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. ...
  6. Dove

    An economic policy advisor who promotes monetary policies that involve the maintenance of low interest rates, believing that ...
Trading Center