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.
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 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