Contango and backwardation refer, normally, to the form of the construction of a ahead curve.
The ahead curve may very well be plots of any asset value throughout time.
Nevertheless, we’re solely involved with the contango and backwardation of the VIX futures time period construction curve.
Why this explicit curve? As a result of it tells us whether or not the equities market (and, by implication, the choices market) are in regular market situation or whether or not there’s unusually excessive worry available in the market.
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The VIX is an index that represents the volatility of the S&P 500 index (SPX).
The exact definition is that it represents the market’s expectations for volatility over the approaching 30 days based mostly on SPX index choices.
However don’t fear about exact definitions. Simply perceive that it’s a gauge of the market sentiment. A excessive VIX implies worry within the market. Low VIX represents complacency.
Because of this the media typically refers back to the VIX because the “worry” index.
You’ll typically see the VIX go up when SPX goes down. And vice versa. Generalizing, VIX goes up when the market is down for the day.
And VIX drops on a market up day. Not all the time, however sometimes.
The query is, at what degree of VIX ought to we contemplate as being excessive?
And what degree of VIX is taken into account low?
Should you ask ten buyers, they are going to seemingly provide you with ten totally different solutions.
Additionally, markets change. A VIX degree that was thought of excessive 5 years in the past is perhaps thought of low as we speak.
Whereas watching the VIX is sweet, waiting for contango and backwardation within the VIX futures time period construction offers added data to the investor.
If you see the curve in backwardation, that signifies that the market is in such a heightened state of worry that it’s close to panic, plus the indicators are extra clear.
Should you ask ten buyers whether or not we’re in backwardation or not, you usually tend to get the identical reply.
The only approach to know whether or not the market is in contango or backwardation is to have a look at www.vixcentral.com.
As I’m penning this, here’s what I see on their homepage as we speak, February 19, 2023:
supply: vixcentral.com
This curve is in contango.
The volatility of subsequent months is larger than the earlier months — with the slight exception of the July and August months.
The vertical axis reveals volatility.
The values are from the CBOE and are delayed costs. Nonetheless, they’re ok for our functions.
The horizontal axis reveals months going ahead.
The leftmost dot (March in our instance) is the upcoming month.
The dot after that (April) represents the month after that.
These two dots are referred to as the “entrance two months.”
Some buyers favor to see how a lot contango there’s in the course of the first two months.
The numbers are highlighted right here:
You’ll be able to consider this because the steepness of the curve for these two months.
The market is in contango nearly all of the time as a result of that’s the default state of the market.
Should you see contango, you recognize that the market is “regular.”
It’s regular for the volatility of the long run months to be larger than close to months as a result of there’s extra time for dangerous issues to occur and extra time for bigger strikes to be made.
Should you see a curve that appears like this:
The market is in backwardation.
The next months are decrease in volatility than the close to months.
Which means there’s an occasion occurring or an impending occasion that’s about to occur that’s inflicting heightened volatility within the close to month.
I pulled up this chart by clicking on the “Historic Costs” tab and setting the date to October 16, 2008 (within the midst of the worldwide monetary disaster).
You’ll be able to return in time to see the contango/backwardation standing of any day previously (until March 26, 2007) by clicking on the calendar and the “Get Costs” button.
Or you may go day-to-day with the “Subsequent Date” button.
You’ll be aware that on the historic charts, the horizontal axis modified to say “Days to Expiration.”
Irrespective of, it’s the form of the curve that we’re taking a look at.
When the time period construction is combined as right here:
We might moderately say it as “combined.” As a result of a combined curve does signify a barely irregular market and we might be reluctant to say that it’s in full contango.
Nevertheless, if we have been compelled to say whether or not it’s contango or backwardation, then we’d take a look at the curve for the entrance two months — as these are the 2 months most quick to us.
If the second month is larger than the primary month (as within the above chart), we’d reluctantly give our reply as “contango.”
Though in our minds, we all know to be cautious because the market will not be in full contango.
If the second month is decrease than the primary month (as within the under chart), then we will say backwardation.
The market will typically undergo a combined state because it transitions from contango to backwardation and vice versa.
A saying that helps as a reminder is that “dangerous issues occur in backwardation.”
Would backwardation have informed us that the Covid crash of February 2020 was not only a regular dip available in the market?
Backwardation confirmed up on February 24, 2020 (a number of days after the beginning of the drop). Backwardation continued with none contango days all the best way till Might 7, 2020, after we acquired again into contango.
Would backwardation have foretold of Volmageddon, the day on February 5, 2018, when the DOW index misplaced 1500 factors intraday?
The market was in backwardation the buying and selling day earlier than, on Friday, February 2, 2018. And continued in backwardation up till February 22.
What in regards to the Flash Crash of Might 6, 2010?
The buying and selling day earlier than was not in backwardation.
However the day of Might 6 was. And the following couple of days after that as effectively.
What proportion of the time is the market in contango?
On a yearly foundation, the market is in contango nearly all of the time.
The precise proportion will depend on the given 12 months.
In bullish years, the proportion of buying and selling days that the market is in contango can be larger.
For instance, contemplate the bullish 12 months of 2021; the market was in backwardation solely on two buying and selling days: January 27, 2021, and December 3, 2021.
Assuming {that a} typical 12 months has 252 buying and selling days on common, the 12 months 2021 was in contango 99% of the time.
On a bearish 12 months like 2022, it has 63 buying and selling days in backwardation.
Therefore, the 12 months 2022 was in contango solely 75% of the time.
The VIX futures time period construction provides us data on market sentiment.
If we see backwardation within the time period construction, we’d contemplate lightening up our positions or taking worthwhile positions off the desk.
For these buying and selling utilizing the Greeks, one would possibly contemplate lowering the whole quantity of constructive deltas or making changes to extend destructive deltas — for instance.
These buying and selling range-bound methods could wish to test to make sure the market will not be in backwardation earlier than initiating a commerce.
Backwardation typically comes with giant market strikes.
These methods, particularly, don’t like for the market to make massive strikes.
Earlier than making a commerce or adjustment, the dealer can even use contango and backwardation to gauge the state of the market.
We hope you loved this text on how contango and backwardation.
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Disclaimer: The knowledge above is for academic functions solely and shouldn’t be handled as funding recommendation. The technique introduced wouldn’t be appropriate for buyers who usually are not accustomed to alternate traded choices. Any readers on this technique ought to do their very own analysis and search recommendation from a licensed monetary adviser.
