OAP 141: Ultimate Guide To Contango And Backwardation Option Pricing

Download The "Ultimate" Options Strategy Guide

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.


  • 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.

Option Alpha Podcast Show Notes[FREE Download] Podcast Show Notes & Transcript PDF: No time to read the show notes right now? We've made it incredibly easy for you to save time by giving you instant access to the complete digital version of today's show. Click Here to Download Your FREE Copy

Free Options Trading Courses:

  • Options Basics [20 Videos]: Whether you're a completely new trader or an experienced trader, you'll still need to master the basics. The goal of this section is to help lay the groundwork for your education with some simple, yet important lessons surrounding options.
  • Finding & Placing Trades [26 Videos]: Successful options trading is 100% dependent on your ability to find and enter trades that give you an "edge" in the market. This module helps teach you how to scan properly for and select the best strategies to execute smarter option trades each day.
  • Pricing & Volatility [12 Videos]: This module includes lessons on mastering implied volatility and premium pricing for specific strategies. We'll also look at IV relativeness and percentiles which help you determine the best strategy to use for each and every possible market setup.
  • Neutral Options Strategies [7 Videos]: The beauty of options is that you can trade the market within a neutral range either up or down. You'll learn to love sideways and range bound markets because of the opportunity to build non-directional strategies that profit if the stock goes up, down or nowhere at all.
  • Bullish Options Strategies [12 Videos]: Naturally everyone wants to make money when the market is heading higher. In this module, we'll show you how to create specific strategies that profit from up trending markets including low IV strategies like calendars, diagonals, covered calls and direction debit spreads.
  • Options Expiration & Assignment [11 Videos]: Our goal is to make sure you understand the logistics of how each process works and the parties involved. If you don’t feel confident in the expiration processes or have questions that you just can't seem to get answered, then this section will help you.
  • Portfolio Management [16 Videos]: When I say "portfolio management" some people automatically assume you need a Masters from MIT to understand the concept and strategies - that is NOT the case. And in this module, you'll see why managing your risk trading options is actually quite simple.
  • Trade Adjustments/Hedges [15 Videos]: In this popular module, we'll give you concrete examples of how you can hedge different options strategies to both reduce potential losses and give yourself an opportunity to profit if things turn around. Plus, we'll help you create an alert system to save time and make it more automatic.
  • Professional Trading [14 Videos]: Honestly, this module isn't just for professional traders; it's for anyone who wants to have eventually options replace some (or all) of their monthly income. Because the reality is that mindset is everything if you truly want to earn a living trading options.

Option Trader Q&A w/ Neil

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today's question comes from Neil, who asks:

Is it really possible to do all these strategies you do with a small $1,500 account and be successful?

Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.

PDF Guides & Checklists:

  • The Ultimate Options Strategy Guide [90 Pages]: Our most popular PDF workbook with detailed options strategy pages categorized by market direction. Read the whole guide in less than 15 mins and have it forever to reference.
  • Earnings Trading Guide [33 Pages]: The ultimate guide to earnings trades including the top things to look for when playing these one-day volatility events, expected move calculations, best strategies to use, adjustments, etc.
  • Implied Volatility (IV) Percentile Rank [3 Pages]: A cool, simple visual tool to help you understand how we should be trading based on the current IV rank of any particular stock and the best strategies for each blocked section of IV.
  • Guide to Trade Size & Allocation [8 Pages]: Helping you figure out exactly how to calculate new position size as well as how much you should be allocating to your each position based on your overall portfolio balance.
  • When to Exit/Manage Trades [7 Pages]: Broken down by option strategy we'll give you concrete guidelines on the best exit points and prices for each trade type to maximize your win rate and profits long-term.
  • 7-Step Trade Entry Checklist [10 Pages]: Our top 7 things you should be double-checking before you enter your next trading. This quick checklist will help keep you out of harms way by making sure you make smarter entries.

Real-Money, LIVE Trading:

  • EWZ Iron Butterfly (Closing Trade): After nearly pinning the stock at our short strikes, and thanks to the volatility drop, we netted a $600 profit on this iron butterfly trade.
  • VXX Short Call (Closing Trade): One of the most consistent and profitable options trades we can make is shorting pure volatility with VXX and today we closed this naked short call in VXX after a couple days for a $420 profit.
  • DIA Iron Condor (Adjusting Trade): This neutral iron condor in DIA is need of a quick adjustment early this week as the market continues to rally. In this video, we'll discuss why I'm adding an additional put credit spread while also choosing NOT to close out of our current put credit spread due to pricing reasons.
  • COP Short Put (Closing Trade): These single short puts in COP acted as a great hedge for our other bearish bets in oil this month and helped smooth out our returns after we closed them for a nice big profit.
  • 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.

Thank You for Listening!

I'm humbled that you took the time out of your day to listen to our show, and I never take that for granted. If you have any tips, suggestions or comments about this episode or topics you'd like to hear me cover, just add your thoughts below in the comment section.

Want automatic updates when new shows go live? Subscribe to the Option Alpha Podcast on iTunes, Google PlaySoundCloud, iHeart Radio or Stitcher right now before you forget - it's fast and easy.

Did You Enjoy the Show?

Please kindly consider taking just 60-seconds to leave an honest Review on iTunes for The Option Alpha Podcast. Ratings and reviews are extremely helpful and greatly appreciated. They do matter in the rankings of the show, and I read each and every one of them!

Also, if you think someone else in your social circle could benefit from the topic covered today, please share the show using the social media buttons you see. This helps spread the word about what we are trying to accomplish here at Option Alpha, and personal referrals like this always have the greatest impact.

About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. In 2018, Option Alpha hit the Inc. 500 list at #215 as one of the fastest growing private companies in the US. 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 three children.