Backwardation and contango are terms often used in commodities trading. These terms describe market conditions related to calendar spreads. These spreads are the price differentials that a commodity has for different delivery times or periods. Backwardation and contango provide traders information on the current state of supply and demand of a particular commodity.
What is contango and why does it matters?
Contango is a market condition in which the future price of a commodity is higher than the current spot price. If a commodity market is in contango, the forward price is in an upward-sloping or normal market. This means that the futures price must go down with respect to the spot price when the time of expiration arrives. Contango normally occurs when the price of a commodity is expected to increase over time, which results in an upward sloping forward curve. It is thus considered a bullish indicator because traders expect a steady increase in the future price of a commodity.
As an example, if the price of a crude oil contract today is $20per barrel but the price for delivery in six months is $35 per barrel then the market is in contango. The terms normal market and positive carry are synonymous with contango.
What is backwardation and does why it matters?
Backwardation is a market condition in which the future price of a commodity is lower than the current spot price. If a commodity market is in backwardation, the forward price is in a downward-sloping or inverted market. This means that the futures price must increase with respect to the spot price as time expires for a particular futures contract. Backwardation is considered a bearish indicator because traders expect the price of a commodity over the long term to decline.
Backwardation can occur when the current demand for a commodity is higher than the contacts maturing in the coming months through the futures market. It is not often seen in the commodities market but it can happen due to disastrous and unexpected events. Backwardation is used by traders to make a profit by selling at the current price of a commodity and then buying at the lower futures price.
As an example, if the price of a crude oil contract today is $35 per barrel but the price for delivery in six months is $20 per barrel then the market is in backwardation.
In conclusion, understanding the difference between backwardation and contango can help traders avoid losses in the futures market. Recognizing when a commodity is in a backwardation or contango market is very important in entering into a long-term position in a futures contract because it informs traders of the potential price direction and sentiments of the market.