Backwardation is a phenomenon seen in the futures market, which futures traders need to monitor. A forward curve is said to be in backwardation when futures are traded at a discount in comparison with spot. Gold backwardation means that traders could potentially gain capital (versus simply buying gold right away) when holding gold futures until the contract expires.
The same is true when a far month delivery is priced lower in comparison with a near term delivery. Or technically, downward slope of forward curve represents backwardation. Backwardation in commodity markets (including backwardation in gold) originates from the supply demand balance, to an extent; in fact, supply demand determines the shape of the forward curve. Near-month futures of a perishable commodity generally trade at a lower price in comparison with spot. Commodities do not follow contango/backwardation strictly; they are highly prone to shifting from contango to backwardation and vice versa depending on the market fundamentals.
The reverse condition where futures trade at a premium over spot is termed as contango.
Let’s detail the situation using an example. Look at the chart below. At t=0 (today) if the futures are priced below spot, the condition is backwardation On the other hand, if the futures trade at a premium over spot, then it is referred as contango. Ideally, both forwards and expected spot are anticipated to merge at maturity.Back