# Understanding Backwardation: Key Concepts and Trading Insights

![Backwardation: When the current price of an underlying asset is higher than prices trading in the futures market.](https://www.investopedia.com/thmb/dJRsXBX_vCi39yo_-rcm--lnB-U=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/backwardation.asp-final-66a475f384d04ac296eabc200556b64b.jpg)

*— Investopedia / Eliana Rodgers*

## What Is Backwardation?

Backwardation occurs when the current price, or spot price, of a commodity is higher than the prices in the [futures market](https://www.investopedia.com/terms/f/futuresmarket.asp). This is usually the result of high demand or shortages that are expected to resolve in the long term.

Backwardation is common in the crude oil market because the constrained supply makes it easy for oil producers to manipulate the market. The opposite of backwardation is contango, when spot prices are higher than the futures price and expected to fall.

### Key Takeaways

*   Backwardation occurs when the current price of an asset is higher than its futures prices.  
    
*   This phenomenon often signals high demand for a commodity now compared to the future.  
    
*   Traders can profit from backwardation by selling short at today's price and buying futures at a lower price.  
    
*   Backwardation can result from supply shortages affecting spot prices in the commodities market.  
    
*   Unlike backwardation, contango is when futures prices are higher than expected future spot prices.

## How Backwardation Impacts Market Dynamics

The slope of the curve for [futures](https://www.investopedia.com/terms/f/futures.asp) prices is important because the curve is used as a sentiment indicator. The expected price of the underlying asset is always changing, in addition to the price of the future's contract, based on fundamentals, trading positioning, and supply and demand.

The [spot price](https://www.investopedia.com/terms/s/spotprice.asp) is a term that describes the current market price for an asset or investment, such as a security, commodity, or a currency. The spot price is the price at which the asset can be bought or sold currently and will change throughout a day or over time due to supply and demand forces.

Should a [futures contract](https://www.investopedia.com/terms/f/futurescontract.asp) 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](https://www.investopedia.com/terms/s/shortselling.asp) 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.

Lower futures prices or backwardation signals traders and investors that the current price is too high. As a result, they expect the spot price will eventually fall as the [expiration dates](https://www.investopedia.com/terms/e/expirationdate.asp) of the futures contracts approaches.

Backwardation is sometimes mistaken for an inverted futures curve, where prices are higher at longer maturities and lower as they approach the present spot price. The opposite of backwardation is [contango](https://www.investopedia.com/terms/c/contango.asp), 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. A shortage in the spot market is the main cause of backwardation in the commodities' futures market. [Manipulation](https://www.investopedia.com/terms/m/manipulation.asp) 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 can suffer significant losses when caught on the losing end of market manipulation.

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](https://www.investopedia.com/terms/a/arbitrage.asp).

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](https://www.investopedia.com/terms/s/shortage.asp) can see their positions change rapidly if new suppliers come online and ramp up production.

## Fundamentals of Futures Contracts

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. These contracts allow investors to take [delivery](https://www.investopedia.com/terms/d/delivery.asp) of the underlying asset at maturity, or offset the contract with a trade. The net difference between the purchase and sale prices would be [cash settled](https://www.investopedia.com/terms/c/cashsettlement.asp).

Pros

*   Backwardation benefits speculators and short-term traders looking to profit from arbitrage.
    
*   Backwardation can be used as a leading indicator signaling that spot prices will fall in the future.
    

Cons

*   Investors can lose money from backwardation if futures prices continue to move lower.
    
*   Trading backwardation due to a commodity shortage can lead to losses if new suppliers come online to boost production.
    

## Comparing Backwardation and Contango

If prices are higher with each successive maturity date in the futures market, it's described as an upward sloping forward curve. This upward slope—known as contango—is the opposite of backwardation. Another name for this upward sloping forward curve is [forwardation](https://www.investopedia.com/terms/f/forwardation.asp).

In contango, the price of the November futures contract is higher than October's, which is higher than July's and so on. Under normal market conditions, it makes sense that prices of futures contracts increase the farther the maturity date since they include investment costs such as [carrying costs](https://www.investopedia.com/terms/c/costofcarry.asp) or storage costs for a commodity.

 When futures prices exceed current prices, it's expected the spot price will rise to match them. For example, traders will sell or short futures contracts that have higher prices in the future and purchase at the lower spot prices. The result is more demand for the commodity driving the spot price higher. Over time, the spot price and the futures price converge.

A futures market can shift between contango and backwardation and remain in either state for a short or extended period.

## Real-World Example of Backwardation in Action

For example, let's say the there was a crisis in the production of [West Texas Intermediate](https://www.investopedia.com/terms/w/wti.asp) crude oil due to poor weather. As a result, the current supply of oil falls dramatically. Traders and businesses rush in and buy the oil, which pushes the spot price to $150 per barrel.

However, traders expect the weather issues to be temporary. As a result, the prices of futures contracts for the end of the year remain relatively unchanged, at $90 per barrel. The oil markets would be in backwardation.

Over the course of the next few months, the weather issues are resolved, and crude oil production and supplies get back to normal levels. Over time, the increased production pushes down spot prices to converge with the end-of-year futures contracts.