A market is considered in backwardation when the forward price of a futures contract is lower than the spot price of the commodity. Make sure you understand that any investment involves risk and that price expectations in futures markets are just predictions, not guaranteed. Backwardation is rare, given that prices typically rise due to inflation as well as storage costs. In this article, we’ll lay out the differences between contango and backwardation and show you how to avoid serious losses. Even if we introduce storage costs into this environment, it wouldn’t justify the existence of futures markets. As long as storage costs are how to buy crypto with venmo known, they could be factored into the pricing formula with interest rates.
How might contango or backwardation affect commodity funds?
Our goal is to deliver the most understandable and comprehensive explanations of financial topics using simple writing complemented by helpful graphics and animation videos. At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content. Thus, there is a positive role return when the market is in backwardation.
Prices Converge at Expiration
- That added a layer of expertise to his work that other writers cannot match.
- Essentially, speculators are betting that the commodity’s price will not increase as much as the market expects, allowing them to profit.
- Even if we introduce storage costs into this environment, it wouldn’t justify the existence of futures markets.
- Speculators may buy more of the commodity experiencing contango to profit from higher expected prices.
- This process, known as “roll yield,” can erode returns over time, particularly in steep contango markets.
The expected spot price twelve months in the future may actually still be $75. This creates an upward sloping curve of future prices over time relative to the current spot price. A market is “in backwardation” when the futures coinbase cryptocurrency traders continue to face frozen funds for weeks price is below the spot price. Contango and backwardation are often found in the crude oil futures market, given that the price of this widely used commodity is highly volatile. If investors think the price of oil will rise, contango will kick in. Conversely, if they think it will fall, as in August 2024, backwardation will result.
Each underlying asset has several separate futures contracts representing expiration dates (and “delivery” dates for physically settled contracts) many months—often years—in the future. So, technically, each contract is a separate asset representing expectations of what the underlying asset will be worth as of the delivery date. In the practical world, most futures contracts are undertaken with the intent to settle them on or before expiry on a cash basis with no real exchange of assets through delivery, making understanding it even more important.
Businesses might also stock up on commodities during periods of contango. As a consumer, you can see that the market expects prices will go up for a certain commodity. You could potentially save money by spending now on that asset versus waiting for the future.
There is always the possibility that the market will fall to levels far below the price you’ve agreed to pay, causing losses. The closer the delivery date, the smaller the window for a drastic change in price. On the last day of the futures contract, the futures price becomes the spot price.
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Essentially, speculators are betting that the commodity’s price will not increase as much as the market expects, allowing them to profit. Contango is considered a normal market condition because assets generally rise in value over time, and physical commodities have carrying costs. Backwardation is the opposite scenario, where futures prices are lower than the expected spot price.
This supply/demand interplay ultimately determines the shape of the futures curve. Contango and normal backwardation are two different market situations in the futures market. While contango refers to a situation where futures prices are higher than the spot price, normal backwardation is a condition where futures prices are lower than the spot price. Normal backwardation generally indicates the market’s expectation that the asset price will decrease over time.
Adam received his master’s in economics from The how to buy xdc on kucoin New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem. In this scenario, the trader would make a profit of $10 on each barrel of oil while storing the physical oil for a few months. Both contango and backwardation can create investment prospects and ways to make money.
Other costs of carry involve financial, interest and insurance costs. Let’s say a contract for future delivery of crude oil is priced at $90 per barrel, for example, but you think the price of oil will be only $85 at that time. If the trade works out as expected, you’d profit at $5 per barrel. If you think the market has pushed the futures price too high because of contango, you could agree to sell a futures contract at the higher price.