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Backwardation bullish or bearish

Thinking about why backwardation in commodities markets is bullish. Created by Sal Khan.

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Video transcript

If a commodities trader tells you that a market is in backwardation, they're essentially saying that it costs more to buy whatever commodity they're talking about now than it would to buy it later, to go into a futures contract to buy whatever that commodity might be-- silver, gold, or oil-- to buy it later. So later is cheaper. So, the question you might ask yourself, or really, any trader might ask themselves, is this bullish or is this a bearish? Is this a bullish situation? And there's no obvious rule of thumb here. But if someone says, look, to get something now costs more than to get it later, what does that tell you about what's happening in the market? Well, it tells you that people are desperate. Because if they weren't desperate, the rational thing to do would just be wait. Wait a little while and get it cheaper for later. Or, if you don't need that oil right now, if you don't need that corn right now, or if you don't need that gold right now, instead of paying more for it right now, just say, look, I could enter into a futures contract for delivery of that gold or oil or corn or whatever it is at a later date for a cheaper price. And I wouldn't even have to store it between now and then. So, if some people were rational and if they weren't desperate, this wouldn't happen. But because they're willing to do this, they're willing to pay more now than for a future delivery date, it shows you that there might be some type of shortage. In the case of oil, maybe the oil supply has been disrupted somehow. In the case of corn, for whatever reason, some crops have been destroyed, and people need to eat, and all of the rest. For commodities that aren't used, so to speak, like gold, if you see backwardation there, I wouldn't say-- I mean, it's definitely still desperation, but it's not out of a core need. If gold goes in the backwardation, it's more because of some type of irrational desire to have their hands on the gold now than have their hands on the gold later. Maybe they think society is going to collapse, and the future delivery dates of gold aren't going to actually hold up. Who knows what they are? So in general, when people talk about backwardation, because of this desperation in the market, people tend to perceive it as a bullish signal. Obviously if people are desperate, there's demand for this thing. My argument is, you can't just look at one tea leaf out of a bunch of tea leaves and say whether it's bullish or bearish. But what you could say is, look, there's something somewhat abnormal going in the market due to some type of desperation. It's a little less irrational it it's due to a storage, but it could be very irrational if it's a due to just wanting your hands on it. Because frankly, if you wanted to buy gold just for the sake of investing in gold-- you're not going to eat it or use it to fuel your car or anything like that-- it would make complete sense, or even better, if you already held gold in this type of a market that's undergoing backwardation. The rational thing to do would be to sell your gold now for more money, and then agree to buy it back later for cheaper. And so once this later date comes about, you'll still have your gold, and you would have made some risk free profits.