Backwardation in Layman's Term?

[AlmostDoneIII]

Has anyone found a good explanation of backwardation and roll yield and contango in Layman’s Term?

Trying to get a better understanding How people use it to earn a positive return.

[AlmostDoneIII]

@daharmattan1

Roll return is the return that comes from rolling a futures contract forward at expiration. It is equal to:

roll return = change in futures price - change in spot price

Roll return can be either negative or positive depending on the term structure of commodity prices. It will be negative when markets are in contango, which means the futures price is greater than the spot price (think crap, contango!). Roll return will be positive when markets are in backwardation, which is where the FP is lower than the spot price.

One more time:

• contango is where Spot price < Futures price
• backwardation is where Spot Price > Futures price

that’s just straight out of the book. Do you have the ability to use it in context? I assume not if you just stated the definition and restated it again. thanks.

[MrSmart]

Roll return is the position where the future price rolls up the future price curve. Like rolling up your sleeve and the cuff (F1) gets closer to your elbows (spot price)

If the future price is below the spot price, then it will move up the curve as time passes and it gets closer to S0, this is a positive return. And the opposite is true.

Picture both backwardation and contango as the 90 degree rotated U shape with the S0 at the bottom of the letter, the X-axis is time, and the Y-axis is price. As the time to maturity goes down, the F1 will move along the curve, and the difference between F1 today and F1 tomorrow, is the roll yield.

This is just one component of future contract returns, the other two are collateral (risk free rate), and the spot price.

[AmruthSundarkumar]

Backwardation occurs when the Futures price is less than the Spot and could occur due to a fear that there might be shortage of supply in the future thus making it difficult to buy the commodity in future. So, commodities may not be sold now but will be stored due to fear of not being able to buy them in the future - related to ‘convenience yields’. Thus, it is a fear premium giving impetus to the spot price.

The futures price approaches the spot price towards expiration. So as you roll your contract towards expiration, you sell your existing contract and buy the next contract at a lower price due to backwardation. This is a positive since you bought a new contract cheaper and sold dear the older one.

Contango occurs when the Futures price is greater than the spot. It can happen if the there is a shortage of storage capacity thus increasing storage costs which can happen due to oversupply of the commodity in the market (like what is happening in the oil markets now - oil is in a contango). The roll yield as you can decipher will be negative for a contango since you will roll the contract by buying the next contract a higher price and selling the existing one lower.

Hope this helps!