Backwardation - profiting from the future

There are certain conditions in the market which require a high level of knowledge to perform within. Backwardation is one of such and can be as profitable as risky. Let’s analyze its initial reasons and ways to invest during this market condition.

Backwardation: Definition

A market state in which the underlying asset’s cost is higher than the price of the same asset within the futures market is also known as Backwardation. It may be described as a common situation within a market because of all the reasonable factors behind it: the commodity storing, insurance and e.t.c.

There are multiple rational reasons for this market condition to occur, so, it’s also possible to gain from such tendencies, especially, when it’s interpreted in the right way. Backwardation can tell the investor about a high probability of the supply’s scarcity or an increased demand for the spot commodity.

Principles of work

To begin with, this situation is confirmed when the asset’s cost is higher than the future one which is determined within the future contracts. It can be a sign of the investor’s desire to purchase a commodity with a premium not in the upcoming future, but in the present (to avoid additional waiting for the delivery).

Mainly, the supply & demand potential together with the market sentiment are connected to the whole Backwardation structure.

Importance

Backwardation can be a very useful tool for many reasons: the market itself and its participants are all affected by the impact of this event. Investors, who prefer a short-term deal, may choose to update their initial plan for an asset and adjust it to gain on the immediate increased valuations. On the other hand, long-term ones may investigate the state of the supply and determine several issues with it. Moreover, the commodity producers can interpret Backwardation as a clear indication to sell, because the existing costs rise above the future ones.

In addition, the economy itself is affected by this condition, especially in the case of commodities. Multiple producers react and adjust to the formed state of the market and it leads to bigger overall changes.

Reasons

Backwardation can be caused by several reasons:

• Disruption of the supply. It is one of the widespread factors which directly causes the condition to form. Many real-life situations can lead to such supply disruptions (Natural disasters, political events and e.t.c). These sudden changes impact on the price directly by increasing the asset’s valuation at the present time. For instance, the flood near the oil factory may cause its destruction. It will be followed by scarcity and the increase of the valuation.

• Demand and its changes. At the same time, if the demand rises quickly, the same increase occurs with the asset’s price. There are also many reasons behind these changes, such as economic growth, consumer’s interest, and any developments – all of which may affect the demand condition. For instance, if the smartphone company develops an innovative technology within their product which will increase the efficiency and simplify the utilization of the smartphone, it will significantly increase the demand.

It is crucial to understand all the signals to interpret them in the most convenient and right way to gain profit from Backwardation. Both supply and demand must be observed with caution which may lead to the right trading call.

Influence

General impression of Backwardation is very strong due to the dynamics it causes within all the layers of the market. There is more than just consequences for the valuation:

• Market Sentiment. Participants of the trading activity are all affected by such events, because both the demand increase and the supply disruption may underlie it. It also indicates the potential volatility increase due to the existing reactions of the investors to growth of the future price or shortages.

• Trading strategies. As a trader determines this condition, he can adjust his trading strategy in a more flexible way. However, the strategy in this case will be difficult for an inexperienced trader, because purchases in the spot market and selling the futures contract isn’t exactly an easy way to profit – it requires a certain level of knowledge of every detail of Backwardation initial reasons and the market’s behaviour itself.
• The economy. The whole situation may cause a huge chain reaction, especially in cases of the highly demanded commodity. If the producers will spend more funds, it may lead to an increase in price for a customer. Right after, there is a high possibility of the inflation rising.

It is a very influential event which causes multiple changes of the variety of market participants. Backwardation has its crucial impact and that’s exactly why it is important to learn all the necessary knowledge about the initial reasons and the consequences it leads to.

Backwardation & Contango: the difference

The key difference between Backwardation and Contango is the designation. Backwardation means that the asset’s spot valuation is higher than the future one. Conversely, Contango designates the price’s lower value in comparison to the future. It may happen during the strong rise of storage expenses which leads to the difference which fits Contango’s definition.

It’s very crucial to notice all the initial factors which predetermine each of them and to investigate all potential changes. If the strategy is adjusted right, an investor can gain profits from these set of conditions.

Trading opportunities

There are several ways to gain an advantage from this sequence of the price behaviour. Arbitrage traders may use it to execute the immediate deals to win from the temporary divergences. On the other side, speculators can use gained information to adjust their next move into a position which will fit their expectations of the potential asset’s cost.

However, it’s not as easy as it sounds and the required level of risk management can be too high for an inexperienced market participant. Both speculators and arbitrageurs must continuously analyze the situation, identify the existing trends and the potential ones and e.t.c. Without research, any misunderstanding can lead to huge losses, especially in highly volatile and unpredictable conditions of the market.

Benefits

First of all, let’s review all the positive sides of trading efficiently during this condition:

1. Gathering trading participants at the same time. Both buyers and sellers, including the investors who search for the commodity’s physical delivery.
2. Holder of the asset, which follows this specific scenario, can cover the carrying price of the underlying commodity.
3. General increase of invested funds due to the rise of the valuation. Short-term traders together with arbitrageurs may be interested in such opportunities to gain additional profit.

Overall influence and multiple possibilities in profiting from this sequence of the price behaviour make it a flexible way to trade.

Drawbacks

Nevertheless, investing during Backwardation has its downsides because of several complications which lead to a list of disadvantages:

1. Investment loss due to the risk of future asset’s price being too low. In this specific case, the funds, which were invested in the commodity, may significantly decrease.
2. Potential selling tendencies which are connected directly to the expectations of the market participants. Majority of them may believe that the cost will decrease in the near future.
3. There are several inside and outside factors which may seriously impact on the cost. The demand in commodities can significantly increase due to natural disasters, political complications and e.t.c.
4. Continuation of this condition may lead to a huge loss, if the market won’t be able to return to normal. The whole investment can be lost in case of this specific scenario.
5. An investment in the commodity may be unprofitable due to the rival supplier which can cause the decrease in demand. The asset’s valuation will be decreased, respectively.

It’s a very sensitive and difficult condition to predict. Only those investors who learned and observed enough can gain profit from such events.

FAQ

What is Backwardation?

A market state in which the underlying asset’s cost is higher than the price of the same asset within the futures market.

Why does Backwardation happen?

It mostly happens because of the Disruption of the supply and changes in Demand.

What’s the difference between Backwardation and Contango?

Backwardation means that the asset’s spot valuation is higher than the future one. Conversely, Contango designates the price’s lower value in comparison to the future.

Which trading strategies can be used during Backwardation?

Speculators and arbitrageurs are the traders who can profit from both Backwardation and Contango.