What's the best way to play backwardation in the futures market?

By Brent Radcliffe AAA
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. What is the difference between an options contract and a futures contract?

    Both futures and options trading are considered advanced forms of market trading, and require additional training or the ...
  2. What is the difference between the dividend yield and the dividend payout ratio?

    Learn the differences between a stock's dividend yield and its dividend payout ratio, and learn why the latter might be a ...
  3. What's the safest way to invest in high-yielding dividend stocks?

    Learn about some of the most important safety factors that you need to consider before you invest in high-yielding dividend ...
  4. What are common strategies traders implement when identifying a Bearish Engulfing ...

    Learn how to spot a bearish engulfing pattern, and learn some of the trading strategies you can implement to take advantage ...
RELATED TERMS
  1. Backwardation

    A theory developed in respect to the price of a futures contract ...
  2. Commercial Real Estate Loan

    definition of a commercial real estate loan
  3. Bidding Up - Securities

    The act of increasing the price an investor is willing to pay ...
  4. Bear Fund

    A mutual fund designed to provide higher returns when the market ...
  5. Cash-And-Carry Trade

    A trading strategy in which an investor buys a long position ...
  6. Exhausted Selling Model

    A pricing model used to estimate when the price floor of a security ...
Related Articles
  1. Options & Futures

    Trading Options on Futures Contracts

  2. Investing Basics

    The Difference Between Options and Futures

  3. Options & Futures

    Contango Vs. Normal Backwardation

  4. First time stock investors may ask, is there any way to buy insurance on stocks to prevent losses?
    Options & Futures

    Stock Safety: Top 3 Ways to Limit Your ...

  5. Investors can use derivative securities to effectively buy insurance on their individual holdings or on their portfolio as a whole.
    Options & Futures

    Can You Buy Stock Insurace? 3 Strategies ...

Trading Center