A trader is suppose to make money when the market is in backwardation. How does this work? The concept as I understand it is that the spot price is higher that the near term futures price and that the furtures must converge to the spot leading to a higher return for the trader. Here is where I get loss. For example if the spot price for oil today is 85.00 and the futures price for March 2011 is say $80.00 how do i profit from buying the March futures? Can someone please explain in a simpler format
If the market for oil remain in backwardation, you may make money from two sources… 1. Price convergence. 2, Roll yield (if the backwardation is worse than when you acquired the first contract)
Borrow crude and sell it on the spot market . Invest the proceeds in going long Crude futures for delivery in March ( locking in a price lower than your cost of the physical oil ). In March , receive the oil from the short seller and return it to the lender of physical. Net profit.
I think there is a difference between contango/ backwardation and relationship between spot and futures prices. that being said, you have better expectation for profit if you are long and the market is in backwardation because let’s say you are long oil at 85$, when you roll to the next maturity you are long oil at cost 80$ increasing your expected return. obvioulsy the opposite is true if you are short. as said, there is a change of arbitrage ( sell spot and buy futures) but that can happen in a market that is in backwardation or contango - I think we should not confuse the two concepts. as a disclosure I am not dealing with commodities you I am not an expert
During backwardation, roll yield is positive since the curve is upward-sloping. You’re buying the futures contract at a lower price and selling at a higher price when you move into the next period’s contract (the roll) to keep your trade open.
ATH Wrote: ------------------------------------------------------- > During backwardation, roll yield is positive since > the curve is upward-sloping. You’re buying the > futures contract at a lower price and selling at a > higher price when you move into the next period’s > contract (the roll) to keep your trade open. Backwardation means the curve is downward sloping - meaning the longer dated contract is cheaper than the shorter dated contract.
LPoulin133 Wrote: ------------------------------------------------------- > ATH Wrote: > -------------------------------------------------- > ----- > > During backwardation, roll yield is positive > since > > the curve is upward-sloping. You’re buying the > > futures contract at a lower price and selling at > a > > higher price when you move into the next > period’s > > contract (the roll) to keep your trade open. > > Backwardation means the curve is downward sloping > - meaning the longer dated contract is cheaper > than the shorter dated contract. You’re totally right, I was thinking of the chart (in my head) that depicts the change in price from today through contract maturity, which is upward sloping. Sorry about the misdirection.
Louis? Is that you? Nice catch.
i think you had it right at the beginning. the futures price must converge to the spot price at maturity, or there would be an arbitrage opportunity. the key assumption is that oil stays at $85. you buy the march contract for $80, hold it until it nearly matures, and if the price of oil hasn’t changed, you would expect to sell it for ~$85, pulling in $5 per notional.