Guide To Contango & Backwardation Option Pricing

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 futures pricing concepts are very easy to understand once you know the relationship between three key items.

Three Major Components:

1. Future Price: The price of a futures contract at any date in the future.

2. Spot Price: The spot price is simply the price of the futures contract today.

3. Convergence: The general idea that as we get closer to the future date, the spot price and the futures price converge until they become the same.

Futures contracts and options contracts share this convergence characteristic. As time and volatility gets sucked out of options contracts, they start to converge closer to their intrinsic value, if there is any intrinsic value, at expiration.
Eventually, when you get to expiration, the price and intrinsic value will be the same.

Contango and Backwardation

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 crude oil contracts are in contango, which again means that the future price is higher than the spot price.
This happens primarily 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 until you are ready for delivery.
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 market going higher.
When crude oil goes into backwardation, most of the time it is due to a short-term increase in demand in oil and very little supply in 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: VIX

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

VXX Contracts

VXX is a leveraged ETF that basically is trying to buy and sell VIX 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 VXX term structure’s makeup requires buying the front-month VIX contract and selling the back month VIX contract.
To start off, VXX buys the front-month futures contract but then, at expiration of the front month, sells the front month and buys the back month contract.
VXX has to sell the front-month VIX futures at a lower spot price and then buy further out VIX futures at a higher price. VXX gets dragged lower because of contango.

VXX in Backwardation?

The only time VXX makes money is when it is in backwardation.
Then, VXX has to sell front month VIX futures at a higher price and buy back month VIX futures at a lower price.

Conclusion

When thinking of contango and backwardation, an understanding of the mechanics of what's going on allows you to tilt a strategy in one direction or another.
Traders use backwardation and contango as triggers of market tops and bottoms.
Having an understanding of contango and backwardation can help you in the future as you select strategies.