Loading the player...

What is 'Backwardation'

Backwardation relates 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 because the spot price is above the futures price, and the contract and spot price must eventually converge, so the future's price rises toward the spot price. 

Breaking Down 'Backwardation'

Backwardation favors those who are net long, since futures prices are increasing toward the spot price. Assume you can buy a one-year oil contract today for $50, but the expected spot price one year from now is $60. That is backwardation, since the price futures price will move toward the spot price. The expected future spot price is always changing, as is the price of the future's contract, based on fundamentals, trading positioning, and supply and demand of the underlying asset.

Contango

Backwardation is the opposite of contango. Contango is when a commodity's or underlying security's futures price is above the expected 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 expected spot price on the commodity is $40 per barrel, the market is said to be "in contango." 

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. The reason that futures prices and the spot price converge is that if they don't there is a riskless profit to be made between the two prices. Therefore, the two prices are driven together as traders try to exploit this. 

Shifting Markets

A futures market can shift between contango and backwardation. It may stay in either state for small or extended periods of time. If a natural gas refinery has a short-term shutdown, that could drive spot prices up, but because it doesn't affect the longer-term outlook, futures further away from expiry remain stable and below the current spot price. This is contango.

On the other hand, a harsh growing season could put an agricultural commodify into backwardation. The current supply of the commodity is not a major concern, but come harvest time there could be supply issues which push up futures contract prices that are further away from expiry.

RELATED TERMS
  1. Contango

    Contango is a situation where the futures price of a commodity ...
  2. Spot Price

    The spot price is the price at which an asset can be bought or ...
  3. Spot Commodity

    A spot commodity is any commodity available for immediate trade, ...
  4. Wide Basis

    A wide basis occurs in the futures market when the spot price ...
  5. Convergence

    Convergence is the movement of the price of a futures contract ...
  6. Forwardation

    A term used in pricing futures contracts. Forwardation is a ...
Related Articles
  1. Trading

    Contango vs. Normal Backwardation

    Learn about the futures curve, contango and backwardation, and what they mean for hedgers and speculators.
  2. Investing

    Is USO a Good Way to Invest in Oil?

    The United States Oil Fund is better suited to short-term investors who actively manage their portfolios.
  3. Trading

    Combining Forex Spot And Futures Transactions

    The spot, futures and option currency markets can be traded together for maximum downside protection and profit.
  4. Investing

    UNG: US Natural Gas ETF Performance Case Study

    Explore the performance of the United States Natural Gas Fund since 2012, including the influence of contango and backwardation on the fund's returns.
  5. Tech

    How are Bitcoin Futures Priced?

    A detailed explanation of how bitcoin futures contracts are priced theoretically and in reality
  6. Investing

    ETFs Provide Easy Access To Energy Commodities

    Hedge against rising energy prices and diversify your portfolio with these funds.
  7. Investing

    DBC: PowerShares DB Commodity Tracking ETF

    Find out about the PowerShares DB Commodity Tracking ETF, and explore a detailed analysis of the fund that tracks 14 distinct commodities using futures contracts.
  8. Trading

    Using Options Tools To Trade Foreign-Exchange Spot

    Find out how delta, gamma, risk reversals and volatility can all help predict movements in the cash market.
  9. Small Business

    What is Backward Integration?

    What is backward integration, and how can it affect industries?
RELATED FAQS
  1. What's the best way to play backwardation in the futures market?

    Backwardation is a market condition in which a futures contract far from its delivery date is trading at a lower price than ... Read Answer >>
  2. Why do futures' prices converge upon spot prices during the delivery month?

    Learn why as the delivery month of a futures contract approaches, the future's spot price will generally inch toward or even ... Read Answer >>
  3. How do I convert a spot rate to a forward rate?

    The spot rate shows the cost of executing a financial transaction today, while the forward rate provides the cost of executing ... Read Answer >>
  4. 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 >>
Trading Center