What is an 'Inverted Market'

In the context of futures markets, an inverted market occurs when near maturity contracts are higher in price than far maturity contracts. Another term for this condition is backwardation.

BREAKING DOWN 'Inverted Market'

An inverted market, or backwardation, is a situation where the futures market price of a commodity is above the expected spot price at the same maturity. Typically, in this type of market, we see the near-month contract above the middle month contract, which is above the far-month contract. The curve of price vs. maturity would be downward sloping.

In contrast, a regular, or non-inverted market, has an upward sloping price vs. maturity curve. Another name for this condition is contango.

When a market is inverted or in backwardation, it describes a situation in which the delivery price of a particular futures contract has to converge downward to meet the future expected price. If prices did not converge, it would set up an opportunity for investors to profit from arbitrage. Inverted situations can be costly to investors holding net long positions since futures prices necessarily fall, all else held constant.

For example, assume an investor goes long with a futures contract at $100. The contract is due in one year. If the expected future spot price is $70, the market is in backwardation, and the futures price will have to fall (unless the future spot price changes) to converge with the expected future spot price.

Causes for Inverted Markets

The most common reason a market inverts is due to short-term disruptions in supply of the underlying. For crude oil futures, that could be an OPEC policy to restrict exports or a hurricane damaging a crude oil port on the Gulf coast. Therefore, deliveries now are more valuable than deliveries later in time.

Agricultural commodities might see shortages due to weather. Financial futures might see short-term price squeezes due to changes in trade policy, taxes or interest rates.

Regular, or non-inverted, markets show near month delivery contracts priced below later month delivery contracts. This is due to costs associated with taking delivery of the underlying commodity now and holding it, or carrying it, until a later date. Carrying costs include interest, insurance and storage. They also include opportunity costs as money tied up in the commodity cannot earn interest capital gains elsewhere.

When the cost of a futures contract equals the spot price plus the full cost of carry, that market is said to be in full carry. Contango markets can be above or below full carry. Clearly, an extreme deviation below a full carry condition could put the market into backwardation.

There is a caveat in that some markets, most notably energy, inverted or backwardation is normal, at least for long stretches of time.

RELATED TERMS
  1. Carrying Charge Market

    Carrying charge market is a futures market where long-maturity ...
  2. Contango

    Contango is a situation where the futures price of a commodity ...
  3. Roll Yield

    Roll yield is the return generated by rolling a short-term futures ...
  4. Convergence

    Convergence is the movement of the price of a futures contract ...
  5. Wide Basis

    A wide basis occurs in the futures market when the spot price ...
  6. Inverted Spread

    An inverted spread occurs when the yield difference between a ...
Related Articles
  1. 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.
  2. Trading

    Beginner's Guide To Trading Futures

    An in-depth look into what futures are, and how you can build a solid base to begin trading them.
  3. Investing

    Bond yield curve holds predictive powers

    This measure can shed light on future economic activity, inflation levels and interest rates.
  4. Trading

    The Future Is Now: All About Futures ETFs

    A new security class - futures ETFs - is gaining popularity. We tell you how futures ETFs work and offer tips.
  5. Trading

    Combining Forex Spot And Futures Transactions

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

    Charles Schwab: Flattening Yield Curve Isn't Reason to Worry About Stocks

    While stock investors have plenty of worries, the flattening yield curve shouldn't be one of them, says Charles Schwab's Liz Ann Sonders.
  7. Investing

    A Quick Guide for Futures Quotes

    Here is a quick guide for reading and understanding futures markets quotes.
  8. Insights

    Four Scenarios: Fed Policy, the Yield Curve and Recessions

    If you were to compile a list of the most effective recession predictors, the term spread, or difference between short and long-term interest rates, would likely be at the top of that list.
RELATED FAQS
  1. What is the difference between term structure and a yield curve?

    Understand the difference between the term structure of interest rates and a yield curve, if any. Learn what the yield curve ... Read Answer >>
  2. What does market segmentation theory assume about interest rates?

    Learn how the market segmentation theory for different maturities of interest rates seeks to describe the shape of the yield ... Read Answer >>
  3. What is the current yield curve and why is it important?

    Understand what the current yield curve represents, and learn how market analysts commonly interpret various changes in the ... Read Answer >>
  4. How do I set a strike price for a future?

    Find out why futures contracts don't have set strike prices like options or other derivatives, even though price change limits ... Read Answer >>
Trading Center