What is backwardation (plain definition)
– Backwardation is a market state for futures contracts in which the current spot price of an asset is higher than the price of futures contracts for delivery at later dates. In other words, the forward (future-dated) curve slopes downward toward the present.
Key terms (defined on first use)
– Spot price: the price at which an asset can be bought or sold for immediate delivery.
– Futures contract: a standardized agreement to buy or sell an asset at a specified price on a specified future date.
– Contango: the opposite of backwardation — a forward curve that slopes upward so futures prices are higher than the spot price.
– Convergence: the tendency for futures and spot prices to approach the same level as a contract reaches expiration.
– Arbitrage: a trading strategy that seeks a riskless profit from price differences across markets or instruments (practical arbitrage is limited by costs and constraints).
Why tilted forward curves matter
– The shape of the futures curve (upward or downward sloping) is used by market participants as a sentiment and supply/demand indicator. Backwardation typically signals stronger near‑term demand or shortage relative to expected future supply; contango often reflects storage and carry costs or expectations of rising prices.
How backwardation arises (main drivers)
– Short-term shortage: physical scarcity of the commodity today pushes the spot price above forward prices.
– Convenience yield: the non‑monetary benefits (availability, production continuity) of holding the physical asset now can make spot more valuable than future claims.
– Supply manipulation or disruptions: production cuts, weather, or geopolitical events can raise the spot price.
– Market structure: delivery constraints, limited storage, or regulatory factors can favor spot over futures.
How it works in practice (mechanics)
– In backwardation
– In backwardation the near‑term (front‑month) futures price is lower than the spot price and is expected to rise toward the spot as the contract approaches expiry. That convergence creates a positive “roll yield” for a trader who holds a continuous long futures position and rolls from the expiring contract into a later one.
Mechanics and who benefits
– Long position (buyer of futures): In backwardation the front‑month futures typically appreciate as it converges to the spot price, producing a positive roll yield when the contract is held to expiry and rolled. That can boost total return for long futures strategies relative to holding spot.
– Short position (seller of futures): Shorts can experience losses from price convergence because the futures they sold at a lower price may rise toward the higher spot price before delivery/settlement.
– Hedgers (producers/consumers): Backwardation benefits producers who want to lock in near‑term sales at high spot levels (they can sell spot or short nearby futures). Consumers may prefer to buy forward if they expect prices to fall.
– Arbitrageurs: If forward prices deviate from no‑arbitrage cost‑of‑carry relationships (which include financing costs, storage costs, and convenience yield), arbitrageurs will attempt to trade cash and futures to capture riskless profit, subject to storage and financing constraints.
Simple roll‑yield numeric example (worked)
Assumptions:
– Current spot S0 = $100
– Front‑month futures F1 = $95 (backwardated relative to spot)
– Next‑month futures F2 = $96
Scenario for a trader running a continuous long futures position:
1) Buy front‑month futures at 95.
2) At expiry the contract converges to spot. If spot remains $100, the futures position becomes worth $100 → unrealized gain $5 (100 − 95).
3) Roll into the next contract: sell the expiring contract (receive $100) and buy F2 at $96. Net cash from roll = +$4 (100 − 96).
4) Effective realized gain from the price convergence portion = $5 initially; when rolling you lock in part of that gain but then are exposed to the new contract price.
Interpretation: The positive amount captured because F1 far) indicates backwardation.
– Indicators: Changes in inventory levels, spare production capacity, and convenience yield proxies (e.g., inventory withdrawal rates) are commonly monitored to explain shifts.
Practical checklist for traders and students
– Verify the forward curve: look at several expiries, not only front month.
– Check inventory and storage reports (for commodities): low inventories often precede backwardation.
– Account for transaction costs and roll frequency: these materially affect realized roll
returns.
– Monitor realized roll yield (define: roll yield — the gain or loss realized when you sell a near contract and buy a further‑out contract as part of a roll) separately from spot returns: record each roll price and quantity so you can compute the cumulative effect.
– Use multiple expiries: if liquidity is thin in month T+1, compare T+2, T+3, etc., to avoid misleading short‑term spikes.
– Account for bid/ask spreads and commissions at roll time: add these costs to negative roll yields or subtract from positive ones.
– When using ETF/ETN wrappers: read the prospectus for the issuer’s stated roll strategy and fee schedule—these products often rebalance on fixed schedules that can materially change realized results.
– Backtest with realistic assumptions: include slippage, margin financing costs, and tax treatment in your simulations.
Worked example — simple monthly roll yield calculation
Assumptions:
– Underlying commodity spot price today (S0) = $100.
– Front‑month futures price (F1) = $102.
– Second‑month futures price (F2) = $101.
– You maintain a constant-long exposure by rolling monthly.
– Ignore financing costs and taxes for clarity; include transaction cost example after.
Step 1 — At start you hold the front contract at F1 = $102.
Step 2 — At roll you sell the expiring front contract for $102 and buy the next contract for $101.
Step 3 — Roll yield per roll = sale price − purchase price = 102 − 101 = +$1.
Expressed as a percentage of spot exposure ≈ 1/100 = +1% per roll. If you roll monthly and conditions persist, simple annualized roll yield ≈ 12% (note: compounding and changing curve shape matter).
Add transaction costs:
– Bid/ask and commissions cost = $0.50 per contract per leg (so $1.00 roundtrip).
Net roll gain = $1.00 − $1.00 = $0.00 → zero net roll yield after costs.
Contango example (same numbers reversed):
– F1 = $98, F2 = $100 → roll yield = 98 − 100 = −$2 = −2% per roll → −24% simple annualized before costs.
Practical formula checklist
– Roll yield per roll = Price_sold_near − Price_bought_far.
– Cumulative roll yield = sum of roll yields across all rolls (account for contract size and number of contracts).
– Net roll return (%) ≈ (Cumulative roll yield / notional_exposure) − total_roll_costs (%).
Note assumptions: futures converge to spot at expiry; liquidity available at quoted prices; ignores margin financing, taxes, and basis changes.
How traders and students can use backwardation in decisions (educational, not investment advice)
– Hedgers: backwardation can reduce hedging costs because rolling short‑dated hedges into cheaper far contracts may produce positive roll yield.
– Speculators: backwardation can indicate tight nearby supply; combine with inventory and demand data before forming a view.
– Portfolio managers: when allocating to commodity futures via ETFs, decompose historical returns into spot return + roll yield + management fees to understand drivers.
Common risks and pitfalls
– Basis risk: futures may not converge fully to the specific cash grade or delivery location you care about.
– Delivery and timing risk: unexpected delivery notices or exchange delivery rules can force position changes.
– Funding and leverage: futures margins can change, producing margin calls that force liquidation unrelated to price beliefs.
– Structural changes: storage technology, regulation, or fiscal policy can change term structure dynamics over long periods.
Step‑by‑step spreadsheet checklist to measure roll impact
1. Collect daily prices for front and next contracts, and spot if available.
2. Record exact timestamps and executed roll prices (not mid‑quotes).
3. Compute roll yield each roll date: sold_price − bought_price.
4. Subtract transaction costs (commissions + estimated bid/ask slippage).
5. Aggregate over your desired horizon and divide by average notional exposure to get percentage impact.
6. Sensitivity‑test for different roll dates and liquidity scenarios.
Further reading (reputable sources)
– Investopedia — Backwardation: https://www.investopedia.com/terms/b/backwardation.asp
– CME Group — Contango and Backwardation: https://www.cmegroup.com/education/articles-and-reports/contango-and-backwardation.html
– U.S. Energy Information Administration (EIA) — Data and storage reports (use
): use for inventories and storage cost estimates): https://www.eia.gov/
– CFTC — Commitment of Traders (COT) reports: https://www.cftc.gov/MarketReports/CommitmentsofTraders/index.htm
– World Bank — Commodity Markets: https://www.worldbank.org/en/research/commodity-markets
Quick worked roll example (numeric)
– Scenario A — Contango (negative roll yield)
1. Front contract sell price = $50.00
2. Next contract buy price = $52.00
3. Gross roll yield = sold_price − bought_price = 50.00 − 52.00 = −$2.00
4. Transaction costs (commissions + slippage) = $0.15
5. Net roll impact = −2.00 − 0.15 = −$2.15
6. Average notional exposure (approximate) = $50.00
7. Percentage impact over the roll = −2.15 / 50.00 = −4.30%
– Scenario B — Backwardation (positive roll yield)
1. Front contract sell price = $55.00
2. Next contract buy price = $52.00
3. Gross roll yield = 55.00 − 52.00 = +$3.00
4. Transaction costs = $0.15
5. Net roll impact = 3.00 − 0.15 = +$2.85
6. Percentage impact = 2.85 / 55.00 = +5.18%
Formulas (for spreadsheet use)
– Gross roll yield (per roll) = sold_price − bought_price
– Net roll impact = gross roll yield − transaction_costs
– Percentage impact ≈ net_roll_impact / average_notional_exposure
Notes: average_notional_exposure can be approximated as the midpoint of sold_price and bought_price or the actual dollar exposure you held.
Practical checklist before you roll
1. Confirm contract sizes and multiplier (e.g., crude oil 1,000 barrels). Convert prices to dollar P&L per contract.
2. Use your executed fills (not mid‑quotes) for accuracy.
3. Record timestamps and available liquidity (bid/ask, depth).
4. Include explicit transaction costs: commissions, fees, and slippage estimates.
5. Adjust for financing/carry if holding leveraged positions or ETFs (borrowing costs, margin interest).
6. Run sensitivity checks for alternate roll dates and price scenarios.
7. Aggregate and annualize if measuring long‑run impact: annualized ≈ (1 + periodic_return)^(periods_per_year) − 1, assuming compounding.
Common pitfalls
– Using mid‑quotes instead of execution prices underestimates slippage.
– Forgetting contract multipliers (leads to large P&L errors).
– Ignoring financing or collateral costs for leveraged products.
– Treating roll yield as profit guarantee—market moves
against you or the curve can flip before you roll. – Ignoring tax treatment—rolls can create short‑term gains/losses taxed at different rates. – Treating index roll rules as irrelevant—ETF/ETN products follow specific index methodologies that materially change realized outcomes. – Over‑aggregating different commodities—mixing products with different multipliers, liquidity, or seasonality hides drivers of roll returns.
Worked numeric example — one contract WTI futures (step‑by‑step)
Assumptions
– Instrument: WTI crude oil front‑month futures. Contract multiplier = 1,000 barrels.
– Executed sell (front month) = $71.00 per barrel. Executed buy (next month) = $70.00 per barrel. This is a backwardated roll (near > far).
– Commissions and fees = $5 round trip per contract. Slippage beyond executed fills (already included above) = $0. Financing/carry ignored for pure futures (note that ETF holders would face financing or borrowing costs).
– Initial margin required per contract (capital at risk) = $6,000 (example; check your broker for actual amounts).
Step 1 — Compute gross roll P&L in dollars
– Sell front @ $71.00 × 1,000 = $71,000 proceeds.
– Buy next @ $70.00 × 1,000 = $70,000 cost.
– Gross roll P&L = $71,000 − $70,000 = $1,000 per contract.
Step 2 — Subtract transaction costs
– Net roll P&L = $1,000 − $5 = $995 per contract.
Step 3 — Express the roll return relative to different bases (choose the one that matches your analysis)
– As percent of initial margin (capital at risk) =
= 995 / 6,000 = 0.16583 = 16.58% (roll gain as a percent of initial margin)
– As percent of notional (market exposure) = 995 / 71,000 = 0.01402 = 1.40%
– Per-unit roll = 995 / 1,000 = $0.995 per unit; as percent of front-month price per unit = 0.995 / 71 = 1.40%
Step 4 — Annualize (only if the same roll repeats regularly)
– Simple annualization (monthly rolls ×12): 1.40% × 12 = 16.80% per year (approximate).
– Compound annualization: (1 + 0.01402)12 − 1 ≈ 18.1% per year (approximate).
Note: annualization assumes you can repeat the same roll return every period and ignores time-varying market structure, financing costs, and taxes.
Step 5 — Interpretations and important caveats
– Different denominators answer different questions: percent of margin shows return relative to collateral posted; percent of notional shows return relative to total market exposure; per-unit shows the absolute price capture you can expect each roll.
– Using initial margin as the denominator can overstate “true” return on capital because margin is collateral, not the economic cost of establishing exposure (which may be financed or hedged).
– These calculations ignore financing/borrowing costs, variation margin, opportunity cost of collateral, and any mark-to-market P&L between trades. They also ignore the risk that the forward curve shape and roll outcomes will change.
– Transaction costs beyond explicit commissions—slippage, bid-ask spreads, and market impact—can materially reduce realized roll returns.
– If you use ETFs or mutual funds that replicate futures rolls, they will have additional management fees, tracking error, and possibly different rollover timing and mechanics.
Quick checklist for computing a futures roll return (practical)
1. Record sell price, buy (next) price