What's the Best Way to Play Backwardation in the Futures Market?

Futures contracts are financial contracts where one party agrees to buy or sell a specific, underlying asset at an agreed upon price at a certain time in the future. These assets vary including commodities and currencies. There are different conditions under which these futures contract trade. One of those conditions is backwardation. But what exactly is it? And how does it work? Read on to learn more about this market phenomenon and how to play it out.

What Is Backwardation?

Backwardation is a market condition in which a futures contract that is far from its delivery date trades at a lower price than a contract closer to its delivery date. So, in other words, the spot price—also known as the market price—for the underlying asset is higher than the futures contract.

A normal futures curve shows increasing prices as time moves forward because the cost to carry the goods increases with long contract expirations. And traders normally 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. This is the general decline in the price for goods and services, and the inflation rate becomes negative. Backwardation is most likely to occur when there is a short-term shortage of a particular commodity—specifically with soft commodities like oil and gas, but less likely to occur in money commodities such as gold or silver. 

Climates Associated With Backwardation

Backwardation happens when demand for an asset exceeds the availability of futures contracts for a particular asset through the futures market. This can sometimes stem from short-term factors leading to fears of scarcity. This includes extreme weather, wars, natural disasters, and political events. Events that fall into these categories include a hurricane threatening to knock out oil production, or disputed vote counts in an election in a country that produces natural gas.

How can investors spot commodities that may have inverted futures curves? Look to the news. You'll find information on how commodities and currencies are moving, and be able to make a determination on how to move on your futures contract.

Identifying Backwardation Futures

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 trades below the spot price, it will increase because the price must eventually converge with the spot price upon contract expiration. Investors who trade futures contracts in commodities considered to be in backwardation are most likely going to hold a long position.

Analyzing price spreads between contracts won't 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.

Pros and Cons of Backwardation

It's important to understand the benefits and risks that come with backwardation. It can be beneficial to short-term investors who try to profit from price imbalances by buying and selling assets on different markets, and for those who engage in speculation. They're able to make a return from price increases in futures prices as it converges with the market price.

But if the spot price remains the same—perhaps because of a specific event—and the futures price continues to fall, the investor may lose out. And considering the fact that backwardation tends to occur when demand is high, there can also be the threat of new producers boosting supply, which can also lower the price for futures contracts.

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