This segment explains two important related concepts of the futures markets, backwardation and contango, and explains their impact on ETFs (and thus ETF options). An understanding of this should help your trading.
Contango and backwardation are terms frequently used when speaking about future prices. This segment explains what they mean and how they affect the products we trade. Also explained is the role of storage cost/carrying cost, the impact of supply and demand, what markets are usually in backwardation or contango and how ETFs that we might trade are affected.
When the front month contracts are more expensive than back month contracts we are in backwardation. This is frequently the case when demand is outstripping supply. When the back month contracts are more expensive than front month contracts the markets are in contango. This is frequently seen when supply exceeds demand. Market sentiment and fear can also help determine if a market is in backwardation or contango.
A graph was displayed of Crude Oil Futures from January 2014 to present. The graph displayed the different times when backwardation and contango occurred. A second graph showed how Crude Oil was in backwardation last year because of supply concerns which made the front months in Crude Oil more expensive than the back months as well as when contango occurs and the front moths are cheaper than the back months.
The futures markets are in contango the majority of the time because of the cost of carry. This is important when trading ETFs based upon futures because of contango’s impact and the subsequent drag. The ETF USO uses futures to replicate spot crude. There is a loss each month in the “roll” (i.e. each month, the fund administrators sell the front-month and buy the back month) when the market is in contango (like now). This creates a drag that willl impact USO.
In VIX futures, the curve is almost always in contango (over 80% of the time), as this creates a negative carrying cost for long VIX traders. This makes sense because long VIX positions act as insurance against market drawdowns. A graph was displayed of the VIX futures curve from August expiration to December 2015 expiration.
VIX futures tend to go into backwardation when market crises occur and IV explodes. This is because the market prices in the mean-reverting tendency of IV and extremely high IV is unsustainable. A backwardated curve results in a positive carry for long VIX traders. Another graph displayed the VIX futures curve from January 2009 expiration to May 2009 expiration. In this rare case the VIX Futures went into backwardation as the graph shows.
Watch this episode of “Closing The Gap Futures Edition” with Tom Sosnoff and Tony Battista to learn all about Contango and Backwardation in the futures markets and how it affects the ETFs and ETF options we like to trade.
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