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Backwardation - Definition
In futures trading, Backwardation is the phenomena where the prices of futures contracts progressively converge upwards towards a higher spot price as expiration draws nearer.
Backwardation - Introduction
Backwardation and Contango are two futures market phenomena which are widely misunderstood. Too many futures traders and analysts, beginners and veteran alike, take Backwardation and Contango to mean normal markets and inverted markets, which is totally wrong. Backwardation and contango refers to the way futures prices behave in relation to spot price over time. They are not terms describing the term structure of futures contract prices.
This tutorial shall explore in depth what Backwardation is in futures trading, how it occurs and how it affects your futures trading.
What Is Backwardation?
Backwardation and Contango refer to the way the price of futures contracts behave as futures expiration draws near.
The Backwardation and Contango phenomena occur due to the fact that futures price and spot price must be the same on expiration day itself as that is the price futures traders will be trading the underlying asset at. As such, futures prices will move towards the spot price as expiration draws nearer even if the spot price remains stagnant. There are really only two ways the price of a futures contract can move when the spot price remains steady; Upwards towards a higher spot price or downwards towards a lower spot price.
When the price of a futures contract move upwards towards a higher spot price, it is known to be in a "Backwardation".
Effects of Backwardation
In a Backwardation, due to the tendency for prices of futures contracts to move higher over time in order to converge with a higher spot price, the odds of winning is with the longs rather than the shorts. Going short in a Backwardation market means you will make a loss when the spot price of the underlying asset goes upwards, when the spot price remains stagnant and when the spot price drops insignificantly. However, going long in a Backwardation market means you will profit when the spot price goes up, stagnant and even when the spot price drops but insignificantly. This means that the only way one can profit being short in a Backwardation market (holding to expiration) is when the spot price drops strongly.
What Causes Backwardation?
Backwardation is a phenomena that has been widely studied