What is 'Backwardation'
Backwardation is a theory developed in respect to the price of a futures contract and the contract's time to expire. As the contract approaches expiration, the futures contract trades at a higher price compared to when the contract was further away from expiration. This is said to occur due to the convenience yield being higher than the prevailing risk-free rate.
BREAKING DOWN 'Backwardation'When backwardation occurs in a futures market, it has been suggested an individual in the short position benefits the most by delivering as late as possible. Backwardation in futures contracts was called "normal backwardation" by economist John Maynard Keynes. He believed a price movement like the one suggested by backwardation was not random but consistent with the prevailing market conditions.
Difference Between Backwardation and Contango
Backwardation is the opposite of contango. Contrary to backwardation, contango is the situation in which a commodity's or underlying security's futures price is above the expected future spot price. Consequently, contango indicates that futures prices are falling over time to converge to the future spot price. For example, if futures contracts on West Texas Intermediate (WTI) crude oil for delivery in six months are trading at $50 while the spot price on the commodity is trading at $40 per barrel, the market is said to be "in contango." Therefore, the WTI crude oil futures curve is upward sloping.
On the other hand, consider a hypothetical market experiencing backwardation in which the spot price of WTI crude oil is trading at $40 per barrel while the futures contract for delivery in three months is trading at $30 per barrel. Therefore, the resulting futures curve is downward sloping, or inverted.
Benefits of Backwardation
The primary cause of backwardation in the commodities' futures market is a shortage of the commodity in the spot market. Since futures prices are below spot prices, investors who are net long 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. Consider the previous example in which futures contracts on WTI crude oil are experiencing backwardation. Assume a speculator who owns oil could sell barrels of WTI crude oil for $40 per barrel. Thereafter, the speculator could purchase the futures contract for $30 per barrel, locking in a "riskless" profit of $10 per barrel.
Learn how to use this market condition to your advantage; check out "What's the Best Way to Play Backwardation in the Futures Market?"