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Inverted Market - Definition
In futures trading, Inverted Market is when the prices of futures contracts on an asset becomes progressively cheaper with longer expiration months.
Inverted Market - Introduction
An Inverted Market in futures trading is when the futures contracts are cheaper and cheaper with longer expiration months. When futures contracts are more and more expensive with longer expiration months, it is known as a "Normal Market".
As you can tell from the name itself, an "Inverted Market" isn't "Normal". Under normal circumstances, futures contracts should be more and more expensive with longer expiration in order to factor in the carrying cost of the underlying asset itself. So, how and why does Inverted Markets happen?
This tutorial shall explore in depth what Inverted Market is in futures trading, how it occurs and how it affects your futures trading.
What Is an Inverted Market?
Inverted Market is one of two possible term structures in the futures market, the other being the normal market. Term structure refers to the way futures contracts across different months are priced, just like what term structure means in bonds trading.
The picture below contains the real futures chains on Dow Jones Index Futures on 11 Oct 2010. Notice that prices are lower the further the expiration month becomes? From 10,899 for the December contracts to 10,893 for the March 2011 contracts.
When prices of futures contracts are progressively lower with longer expiration months, it is known to be in a Inverted Market or having an inverted term structure. It doesn't matter if the prices are generally higher than or lower than the spot price. As long as futures prices are progressively lower with longer expiration, it is known as a Inverted Market. The diagram below shows three different possible forms of Inverted Markets.
A lot of people refer to Inverted Markets as contango markets and inverted markets as backwardation markets. It must be made clear that contango and backwardation has to do with the price behavior of near term contracts as expiration draws nearer. They are not terms to describe the term structure of futures contracts.
Effects of Inverted Markets
In a Inverted Market, futures contracts with longer expirations will be cheaper than futures contracts with nearer expiration. As such, when you roll forward futures contracts in a Inverted Market, you would be able to do so at a lower price maintaining the same number of contracts or increasing the number of contracts using the same amount of money. This will increase your leverage as you roll your futures position forward.
What Causes Inverted Markets?
Futures markets were initially made for the commodities market. In such markets, futures prices are progressively higher with longer expiration because theoretical futures price under the no-arbitrage principle is made up of the current spot price plus storage costs for holding the physical product and other forgone opportunity costs such as interest. This results in a "Normal Market".
Inverted market conditions exist for commodity futures markets when there is a severe lack of supply for the physical commodity in the short term. This causes producers to rush into the futures market in order to secure prices for the purchase of the commodity for the short term, pushing up short term futures prices. This means that in an inverted market, demand for the underlying asset is higher for the short term than the long term. This is especially true for physical assets such as commodities.
Inverted markets is however, the norm in financial futures such as index futures which are not actual deliverable assets. Single stock futures do not fall under this category as the underlying stock itself can be delivered and traded as a physical asset. This is also why Single Stock Futures normally display normal market characteristics. Index futures, however, are based on an index which isn't a physical deliverable asset. As such, there are no storage costs involved and holders of such futures instead lose out on the interest they would have earned by keeping cash in their banks. This becomes a detriment to holding the futures contracts instead of keeping it in cash and with longer expiration, more interest is foregone. This is why financial futures such as index futures normally display inverted market characteristics as the loss of interest that would have been otherwise earned in cash is factored into the price.
As Inverted Markets and normal markets are both a result of supply and demand, the term structure of some commodities futures tend to be seasonal as well. There are commodities that juggle between Inverted Market and normal markets based on their seasonal trends.
Inverted Markets in Contango and Backwardation
Inverted Markets can happen in both a contango market or a backwardation market. However, Inverted Markets are most commonly associated with backwardation due to the fact that the futures prices of most inverted market contracts are below spot price. In fact, most traders take inverted and backwardation to mean the same thing, which is wrong of course.
An Inverted Market in backwardation is truly a long's paradise. It is when you will experience positive roll yield whenever you roll your futures position forward during expiration and always be able to roll forward with more leverage.