What is Option Backwardation?

In our endeavor to make options trading as accessible and user-friendly as possible here at Lantern, we highlight advanced trading terms and concepts. When our users encounter a new situation, they are prepared with the knowledge to make wise decisions.

Today we will dive into some supply and demand curve terminology that Arbitrage Traders utilize in the Futures markets — Backwardation and Contango.

You might be surprised to see Futures Trading on lanterns education platform, but it’s important to remember that you can trade options on Futures contracts like the S&P 500 futures, for example.

Core Concepts

Before we dive into backwardation in contango, we need to define our terms for the relationship between supply and demand In the Futures Market.

Spot Price

The spot price of a commodity or security is its current market price right now. If you were to buy that commodity or security, the spot price it’s what you would pay for it today.

Forward Price

The forward price of a commodity or security represents what its price could be in the future on a given date. You can think of a commodity’s forward price similarly to an expiration price for an options contract.

They are not the same; however, the forward price is a representation of the market’s guess as to what the price will be in the future.

Convergence

Convergence is the crucial element in a Futures trade where the spot price And Futures price match.

Backwardation

Backwardation is a rare situation when the spot price is higher than the forward price of a futures contract.

Disaster and sharp decreases in supply are usually the cause of prices falling into backwardation.

For example, if a tornado wipes out a crop of peaches or an oil rig dumps oil into the ocean, then the supply of those commodities drops, while the demand is the same. Since demand is higher than supply, the spot price will shoot up because consumers need those goods today.

The forward price may not change because the market assumes that the supply will return to normal levels in the future.

Contango

Contango is a situation where the futures price for a commodity is higher than the spot price. There are many reasons for a Contango contract, but the most common is to avoid carry costs.

When someone purchases a futures contract and plans to take physical possession of the assets at expiration, they may buy a contract in contango.

Physical commodities require storage space, transportation, and possibly maintenance, such as feeding livestock.

If a firm or corporation does not need immediate access to the asset and anticipates the spot price to rise in the future, they are usually willing to pay the premium. This is so they can avoid carrying costs until they need the assets.

Contango Arbitrage

Advanced traders utilize contango scenarios as potential arbitrage opportunities. Arbitrage is when a trader purchases a security in one market and immediately sells it at a higher price in another market.

With futures contracts in contango, the trader purchases a contract at the spot price (which is lower) and immediately sells a forward contract and pockets the difference for a profit.

Arbitrage trading requires a lot of leverage and experience and is not recommended for newer traders, but it can be profitable for seasoned investors.

Trading Application

Now that we have demystified contango and backwardation, we can review how they affect our potential options strategies and how we respond to changes in the futures market.

When a futures contract is in contango, the spot price is lower than the future price. Higher future prices indicate an optimistic sentiment and that the value of the commodity will increase as time passes.

If you find a contract in contango, then you may implement a bullish options strategy on some companies within that sector or on indices that hold those contracts.

Backwardation occurs when the spot prices shoot above the future price. This is usually preceded by a natural disaster or sudden increase in demand that supply is not prepared for.

When a commodity falls into backwardation, it may be a favorable opportunity to take a short position on the underlying industry since the price will most likely fall back to equilibrium.

Tying it all together

Now that we have a grasp on the concepts of backwardation and contango, we can take this knowledge and apply it to your options trades on equity futures.

While backwardation does not guarantee a profitable arbitrage opportunity, it can certainly help identify supply and demand discrepancies in the market for short-term trades.

Let us know what you think and if you’ve observed backwardation or contango in practice!