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# Backwardation

Backwardation and the theory of Normal Backwardation. Created by Sal Khan.

## Want to join the conversation?

• the way i understand it from listening to this videos is that in backwardation, there is actually a difference in opinions on what the price will be in the future.
Basically oil sellers are convinced that oil price will lower in the future while someone else, don't quite get who, is expecting it to maintain prices.., i would place my bet on the person producing and selling.
Also, it seems to me that this is like trying to predict the course of an electron, by merely looking at it you are changing its course.
In here, when buying a future, seems to me one is already affecting oil price in the future...
• what is the difference in long call n short call ?
what is the difference in long put and short put ?
• If you are long an option, it means you have purchased an option. If you are short an option it means you have sold an option short (also referred to as writing an option).
• I've watched both videos on Contango and Backwardation, and I still don't understand why the price movements over time has to converge towards the spot price. What is Spot Price, and what role does it play in Future Price Expectations ? Also, can anybody explain the Price Movements over time graph for oil to me, please ?
• Spot price is the price right now, "on the spot". Let's say the spot price of a barrel of oil is \$70 today.
You and I might both try to predict what the spot price will be in 1 year. Maybe you think it will be \$50 and I think it will be \$100. You might offer me a deal: you will sell me a barrel of oil one year from today, Dec 3 2015, at a price of \$90. I should think that is a bargain, because I expect the price in one year to be \$100. You would be happy to sell it to me, because you think you will be able to buy the barrel then for \$50 and sell it to me for \$90, a profit of \$40 - if you are right. If you want to, you could even buy the barrel right now for \$70, keep it in your garage for year, and sell it to me in 1 year as agreed for \$90, making a profit of \$20, minus whatever the cost was for you to store the barrel and finance its purchase. Notice that your profit is lower in that scenario, because you reduced your risk - you no longer have to worry whether you were correct about the spot price going to \$50.

Likewise, I could buy the barrel and put it in my garage, and then pat myself on the back next year when oil is \$100 and I bought my barrel for only \$70.

Whether you and I can reach agreement on a deal now depends on our views of the future price, our risk appetite, and our cost of storage and financing. We have very different views of the future price, so there's a good potential for a deal.

But now let's say that 364 days have gone by, so it is 12/2/2015. The price of oil is \$60. Do you still believe that it will be \$50 on 12/3/2015? Probably not. Do I still believe it will be \$100 on 12/3/2015? Probably not. We probably both think the price is will be close to \$60. If you and I did that deal, I am holding a contract to buy at \$90, and that contract is worthless. You have an obligation to sell at \$90, and you don't need to worry about it. The futures price from a trade on 12/3/2014 has converged toward the spot price of \$60.
• How is Sal determining the movement in the spot price? He is saying it (Orange line in the graph on the right) is not moving much? Moreover, why the future's price as we move closer to the delivery date has to converge to the spot price? Is there a formula to determine this in theory?
(1 vote)
• The futures price is what we currently think the spot price will be on some future date. Let's say the date is Dec 31. It's still more than a month away, so we are not sure about what the spot price will be then. But on Dec 30, we have a pretty good idea what the spot price will be on Dec 31, and the futures price will reflect that knowledge.
• Why does the future price have to converge with the spot price? I still do not understand that.
(1 vote)
• On the day the future expires, doesn't there have to be only a single price for the commodity?
• What is the difference between options and futures ?
(1 vote)
• In this example, wouldn't you be able to make easy money by buying a future and just waiting for it to converge toward the spot price and then selling it? I'm guessing maybe the differences aren't that big, so you wouldn't get much more than through other types of investments. Is this correct?
(1 vote)
• I still don't understand why oil producers would sell their oil below the theoretical expected futures price. Isn't it a bad idea since their profit margin decreases that way?
(1 vote)
• so say if i sell a futures contract to another party, which basically puts an obligation on me to sell oil to that part 50 bucks but as we reach the date the spot price is a \$90
So the question is am i still obligated to sell my oil at 50 buck to that party to honour my futures contract or can i sell the oil at the spot price which is a \$100 now
(1 vote)
• You have to sell your oil to the holder of the futures contract for \$50. That's the whole point of the contract.
(1 vote)
• What would possibly happen to sellers of oil who agree to sell oil at a price of \$50 8 months from the present if hypothetically ALL buyers expected the price to be only \$30 ? Would the sellers have to alter the contract so that they may have sales, or once the contract is locked, the buying side is obligated to purchase oil at the agreed price regardless of the price volatility ?