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What is Backwardation?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 04 November 2016
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    Conjecture Corporation
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As a phenomenon that occurs from time to time with options and futures, a state of backwardation exists when the spot or current price of a given commodity is higher than the projected or forward price. In short, the price of the futures in the near delivery months is significant more than the price that is set for the distant delivery months. Here are some factors that may contribute to the occurrence of backwardation.

There are several factors that may lead to an incident of backwardation with a given set of futures. One has to do with naturally occurring events, such as disasters involving weather. Hurricanes, earthquakes, and droughts can have a significant impact on both current prices and also projected prices in the months to come. Futures may be anticipated to drop in value during a recovery period, if the main source of those futures has recently suffered through some sort of natural disaster. However, if the futures can be held on long enough to get through the period of recovery, there is every chance that the period of backwardation will end and the futures will resume an upward trend in pricing.

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In like manner, the incidence of civil unrest or even war can also have an impact on the current and projected state of futures pricing. Prolonged periods of armed conflict may inhibit the rise of futures prices for a long period of time, making them unattractive to many investors. As with natural disasters, futures that are depressed during wartime often flourish in the first few years after the end of the conflict. Any investor who can afford to hang on to the futures during the time of backwardation often realizes an excellent return in later years.

Typically futures markets tend to operate with a lower price futures price in place currently, and with an expectation that the futures will rise in value in the months to come. The hope is that the upcoming delivery months will realize a price that slowly increases with each successive delivery period or at the very least maintains a level price. Generally, it is not considered to be a particularly good sign when the current futures price is anticipated to exceed the price of a few months down the road. Investors tend to want to unload futures that appear to be entering a state of backwardation, although this may not be the most effective strategy in the long term.

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