Backwardation Definition: A backwardation occurs when the futures market price for an underlying asset is greater than the present price, often known as the spot price.
Backwardation may occur if there is more demand for the commodity right now than there is for contracts that will mature through the futures market in the upcoming months.
Contango vs backwardation
- Contango and backwardation are concepts used to describe the forward curve’s structure.
- In a contango market, the forward price of a futures contract is more than the spot price.
- When a market is in backwardation, the futures contract’s forward price is less than its spot price.
Advantages of Backwardation
- It moves the market by connecting buyers, sellers, and investors together who are either speculating or looking to take actual delivery of products.
- Backwardation reduces the cost of transporting for the owner of the product in its current state.
- Lack of supply in the spot market causes backwardation in the commodity futures market.
- More and more investors are starting to invest in the product market as prices rise. It moves the market by bringing in funds.
Disadvantages of backwardness
- The investment in the product will decline significantly if the futures price is too low. Backwardation can cause investment losses.
- More market players may decide to sell their investments if there is a backwardation situation. Prices for products are predicted to decline soon.
- An unfavourable situation, such as war or a natural disaster, might cause backwardation. Markets for products can be impacted, and in the end, demand for all products rises.
- Investors risk losing their money in a backwardation if the market doesn’t stabilize or keeps falling.
