A cash and carry strategy involves selling a futures contract against a long position in the spot market. That way, fund houses pocket a fixed return, as the premium decays over time and converges with the spot price on the expiry date.
Carry traders usually execute the short futures leg in far-month contracts, offering higher premiums than near ones. In the process, they end up pushing the premium on far-month contracts lower. Another factor that makes the CME futures vulnerable to backwardation is the low retail participation.
Despite the bigger lot size, the exchange offers relatively low leverage than its unregulated peers, such as Binance. Read on to learn more about this market phenomenon and how to play it out. Backwardation is a market condition in which a futures contract that is far from its delivery date trades at a lower price than a contract closer to its delivery date. So, in other words, the spot price—also known as the market price—for the underlying asset is higher than the futures contract.
A normal futures curve shows increasing prices as time moves forward because the cost to carry the goods increases with long contract expirations. In backwardation, this curve is inverted. Investors look at futures backwardation as a sign that price deflation is on the horizon. This is the general decline in the price for goods and services, and the inflation rate becomes negative. Backwardation is most likely to occur when there is a short-term shortage of a particular commodity—specifically with soft commodities like oil and gas, but less likely to occur in money commodities such as gold or silver.
Backwardation happens when demand for an asset exceeds the availability of futures contracts for a particular asset through the futures market. This can sometimes stem from short-term factors leading to fears of scarcity. This includes extreme weather, wars, natural disasters, and political events. Events that fall into these categories include a hurricane threatening to knock out oil production, or disputed vote counts in an election in a country that produces natural gas.
How can investors spot commodities that may have inverted futures curves? Look to the news. You'll find information on how commodities and currencies are moving, and be able to make a determination on how to move on your futures contract. One way to identify futures that are experiencing backwardation is to look at the spread between near-month contracts and contracts that are further out.
If a futures contract trades below the spot price , it will increase because the price must eventually converge with the spot price upon contract expiration. Investors who trade futures contracts in commodities considered to be in backwardation are most likely going to hold a long position. Analyzing price spreads between contracts doesn't always provide the most accurate view of what will happen with a futures contract.
Should a futures contract strike price be lower than today's spot price, it means there is the expectation that the current price is too high and the expected spot price will eventually fall in the future. This situation is called backwardation. For example, when futures contracts have lower prices than the spot price, traders will sell short the asset at its spot price and buy the futures contracts for a profit.
This drives the expected spot price lower over time until it eventually converges with the futures price. For traders and investors, lower futures prices or backwardation is a signal that the current price is too high. As a result, they expect the spot price will eventually fall as the expiration dates of the futures contracts approaches. Backwardation is sometimes confused with an inverted futures curve. In essence, a futures market expects higher prices at longer maturities and lower prices as you move closer to the present day when you converge at the present spot price.
The opposite of backwardation is contango , where the futures contract price is higher than the expected price at some future expiration.
Backwardation can occur as a result of a higher demand for an asset currently than the contracts maturing in the future through the futures market.
The primary cause of backwardation in the commodities' futures market is a shortage of the commodity in the spot market. Manipulation of supply is common in the crude oil market.
For example, some countries attempt to keep oil prices at high levels to boost their revenues. Traders that find themselves on the losing end of this manipulation and can incur significant losses.
Since the futures contract price is below the current spot price, investors who are net long on the commodity benefit from the increase in futures prices over time, as the futures price and spot price converge.
Additionally, a futures market experiencing backwardation is beneficial to speculators and short-term traders who wish to gain from arbitrage. However, investors can lose money from backwardation if futures prices continue to fall, and the expected spot price does not change due to market events or a recession. Also, investors trading backwardation due to a commodity shortage can see their positions change rapidly if new suppliers come online and ramp up production.
Futures contracts are financial contracts that obligate a buyer to purchase an underlying asset and a seller to sell an asset at a preset date in the future. A futures price is the price of an asset's futures contract that matures and settles in the future. For example, a December futures contract matures in December. Futures allow investors to lock in a price, by either buying or selling the underlying security or commodity.
Futures have expiration dates and preset prices. In the case of oil, maybe the oil supply has been disrupted somehow. In the case of corn, for whatever reason, some crops have been destroyed, and people need to eat, and all of the rest. For commodities that aren't used, so to speak, like gold, if you see backwardation there, I wouldn't say-- I mean, it's definitely still desperation, but it's not out of a core need.
If gold goes in the backwardation, it's more because of some type of irrational desire to have their hands on the gold now than have their hands on the gold later. Maybe they think society is going to collapse, and the future delivery dates of gold aren't going to actually hold up. Who knows what they are? So in general, when people talk about backwardation, because of this desperation in the market, people tend to perceive it as a bullish signal. Obviously if people are desperate, there's demand for this thing.
My argument is, you can't just look at one tea leaf out of a bunch of tea leaves and say whether it's bullish or bearish. But what you could say is, look, there's something somewhat abnormal going in the market due to some type of desperation. It's a little less irrational it it's due to a storage, but it could be very irrational if it's a due to just wanting your hands on it.
Because frankly, if you wanted to buy gold just for the sake of investing in gold-- you're not going to eat it or use it to fuel your car or anything like that-- it would make complete sense, or even better, if you already held gold in this type of a market that's undergoing backwardation.
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