OAP 141: Ultimate Guide To Contango And Backwardation Option Pricing

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In the futures trading world, there are two words that sound cool to say but also might be very confusing for new traders; contango and backwardation. Yet, both of these future pricing concepts are very easy to understand once you know the relationship between three key items. In today's podcast, I want to slowly walk through the concept of contango and backwardation while offering a couple different examples to show you how it works in real life and how we might be able to use the awareness of futures pricing as part of an options strategy in our portfolio.

Key Points from Today's Show:

Three Major Components:

1. Forward Price

  • The price of the futures contract at any date in the future.
  • Simply talking about the price of the future delivery of it.

2. Spot Price

The spot price is simply the price of it today.

3. Convergence

The general idea that as we get closer to the future date, the spot price and the future price start to converge until at one point they become the same.

  • As time and volatility gets sucked out of option contracts they start to converge closer to their intrinsic value, if any intrinsic value, at expiration.
  • Eventually, when you get to expiration, the prices will end up being the same. 

Contango: whenever the future price is higher than the spot price.

Backwardation: whenever the future price is lower than the spot price. 

Example 1: The Oil Markets 

  • Many times the oil contracts can be in contango, which again, means that the future price is higher than the spot price. 
  • The reason this happens is mainly because of the cost to hold, store, and carry oil from today until the future. 
  • If you buy a futures contract but you don't want delivery of oil until 6 months from now, you're paying for that futures contract now and someone else has to hold the oil for the 6 months. 
  • This cost to carry and store has to be factored into the future price. 
  • So they take today's spot price and add on the extra cost to carry.
  • The higher future price is therefore not necessarily related to the markets going higher.
  • When crude oil goes into backwardation, most of the time it is because of a short-term increase in demand in oil and very little supply on the market. 
  • Prices then go up so fast that they surpass the futures contracts. 
  • As companies push their oil to market, prices will go back down.

Example 2: VXX

  • Most of the time the VXX is actually in contango because people are fearful the further we go out in time.
  • The further we go out in time, the less predictive power we have as a financial community.
  • Therefore VXX futures further out are a little bit more expensive than VXX futures a little closer in. 
  • A rare spike in volatility can cause a short-term panic and demand for risky assets like VXX futures.
  • The near, front-month contracts are bid up as opposed to the back-month contracts.
  • That's when the VXX goes into backwardation and the spot price becomes much higher than the future price. 
  • The long tail of the VXX does not go up as much because people know intuitively that time heals a lot of wounds.
  • Short-term volatility today may definitely slow down over the course of the next 4-6 months. 

VXX Contracts

  • A leveraged ETF that basically is trying to buy and sell VXX contracts all the time.
  • If you look at a chart of VXX it's lost 99+% of its value since inception.
  • They keep readjusting it, constantly dragging it lower. 

How does this happen?

  • The reason it keeps getting dragged lower is because of contango.
  • The makeup of the VXX term structure is that it has to buy the front-month contract and sell it at the same time it buys the back month contract. 
  • To start off, the VXX buys the futures contract but then at expiration of the front month it sells the front month and it buys the back month contract. 
  • Literally has to sell the front month VXX futures at a lower spot price and then buy further VXX futures at a higher price.

VXX in Backwardation?

  • The only time VXX makes money is when it is in backwardation. 
  • Now VXX is having to sell front month VXX futures at a higher price and buy back month VXX futures at a lower price.

Conclusion

  • When thinking of contango and backwardation, understand the mechanics of what's going on so that you can tilt a strategy in one direction versus the other. 
  • Traders use backwardation and contango as triggers of market tops and bottoms.
  • Having an understanding of contango and backwardation in the market can help you in the future.

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Real-Money, LIVE Trading:

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  • TSLA Put Debit Spread (Closing Trade): Although many people thought we were crazy for getting bearish in TSLA this pre-earnings put debit spread trade made us $200 today. After the huge run up from $140 to $260 and getting some technical sell signals, we were pretty sure this stock would pull back.
  • MON Iron Condor (Closing Trade): Following a huge drop in implied volatility we worked hard to close this MON iron condor trade adjusting the order multiple times to fill before the end of the day.
  • IBB Call Debit Spread (Opening Trade): We'll show you how I started searching for a new bullish trade and eventually found a low volatility trade in IBB looking for a move higher to hedge our portfolio.
  • TLT Iron Butterfly (Closing Trade): Following the Brexit vote TLT and bonds traded in a nearly $8 range really quickly - even still the drop in implied volatility helped generate a $330 profit for us.
  • XBI Call Debit Spread (Closing Trade): Got lucky picking the exact bottom for our entry in this call debit spread for the XBI biotech ETF which ultimately was closed for a profit of $165 today on the rally higher.
  • COH Iron Butterfly (Earnings Trade): Shortly after the market open we close out of our COH earnings trade for about a $160 profit, leaving just 1 leg on to expire worthless.
  • EWW Debit Spread (Closing Trade): Using some of the technical analysis signals we discovered in our backtesting research, we were able to make a quick $130 profit on this bearish EWW debit spread trade.
  • IBM Iron Condor (Earnings Trade): Shortly after the market opened you'll follow along with me as we watch volatility drop and liquidity come into the market before closing out the position for $250 profit.
  • SLV Short Straddle (Opening Trade): Using our watch list software we decided to continue to add to our existing SLV short straddle position with a new set of strike prices reflective of the move lower in the ETF recently.

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About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and two daughters.