Contango vs backwardation...these are two terms that I guarantee you have no idea what they mean...
And that's not a bad thing. The truth is, many investors and traders have been incredibly successful in their careers without having the slightest clue as to what contango or backwardation are, let alone the difference of contango vs backwardation.
In fact, contango vs backwardation doesn't even come into play when we speak about most stocks. For example, knowing what contango or backwardation are does not give any benefit to you if you are looking at placing an investment in a stock like Tesla or Google or Apple.
However, all products that are priced off futures products do have aspects of contango vs backwardation in them. And the difference between making money or losing money (and not knowing why) may be realized after you learn exactly what these two SAT terms are.
And the truth is, you probably don't even know which products are priced off futures. It may surprise you, but it is quite a few, and they are some of the more popular products out there (hint: ALL of the $VIX products).
So strap on and enjoy the ride. We are going to do a few things in this article. First, we are going to talk about what contango vs backwardation is. Then we are going to give you a few examples of how some of the more popular futures based products out there get whipped around from either being in contango or backwardation (yes, they are a state of being).
Here we go...what the heck are contango and backwardation and how will this impact my bottom line...
What Are Futures Products?
The best way to talk about what backwardation and contango are is the go right in and give an example. In the beginning of this article, we spoke about how these concepts of contango and backwardation come into play for futures products and their corresponding stocks that are priced off those futures.
But first, what are futures?
Below is an excellent video showing exactly what futures products are. And don't worry, we will give our own explanation after....
The futures market has its origins in the commodities industry. Farmers, oil and gas producers, miners, and others whose business it is to product commodoties wanted a way to manage the risk of having to accept an uncertain price for their future production. Futures contracts were the answer, and they met the needs of many market participants.
How a futures contract works is actually fairly simple. Under a futures contract, the contract seller agrees to sell a fixed amount of a certain commodity to the contract buyer on a particular day in the future. Most importantly, the price that the buyer will pay the seller is set based on the prevailing futures market price at the time the two parties enter into the contract.
The stock market was created way back when in order to allow individuals access to ownership (equity) in companies. This is only a small case of investments at this point as the entire stock market is now used for money making purposes and speculation.
Similarly, the futures market was created so that commodity providers could lock in prices to sell their crop at at a future date. For example, if Fred the farmer is not certain that his crop two years from now will sell for the same price that is currently the fair market value, he can sell his crop (that will not be ready for two years) on the futures market and lock in those prices now. Fred the farmer feels great because he would be totally okay getting the current price for his crop two years now.
But just like the stock market, the futures market is rarely used for the way it was intended. The futures market is even more speculative when compared to the stock market because of the excessive leverage trader get for these contracts.
For example, one corn futures contract is equivalent to 5,000 bushels of corn. A trader gets to carry $18,725 of corn (5,000 bushels) for the price of $825. That is over 22:1 leverage.
Then we have oil futures. One of these contracts is the equivalent of 1,000 barrels of oil. Those 1,000 barrels of oil have the notional value of $47,140 and only cost an investor $2,970 in margin to trade one contract. That is over 15:1 margin.
And then there are currency futures. The Euro FX futures, which are one of the most popular currency futures, require $2,750 of initial margin to carry $140,581.25 in notional value. This is a big one as right now the Euro FX futures allow investors and traders over 51:1 leverage out of the box.
As you can see, with this kind of leverage, it is hard to see any trader passing up this opportunity...
What is Backwardation?
Here is the thing...
Futures contracts all expire at a point in time. When one expires and people still want to trade that same product, what do they do? They move their positions to another month.
In effect, they are keeping their positions and beliefs alive by doing this. However, the price for the newer futures contract might not be the same as the one they just had...
Let's look at an example of what backwardation looks like to give you a better understanding of what backwardation actually is. Remember, at some point we are going to need to see the difference between contango vs backwardation. So here we go...backwardation time.
If we take a look at the Last X column in the middle of the above screenshot, we see the following prices for the VIX futures contracts that expire from two to thirty days from now. We see:
- We see/VX23M7 expiring in 2 days for $10.15
- We see /VX24M7 expiring in 9 days for $10.85
- We see /VXM7 expiring in 16 days for $11.50
- We see /VX26M7 expiring in 23 days for $11.75
- We see /VX27N7 expiring in 30 days for $12.30
We see the futures contracts that are closest to expiring being lower priced when compared to the contract with more days left in them until they expire. This my friends, is known as backwardation. It is the prices of further out expiring futures contracts being more valuable than those closest to expiring.
The reason for this? When looking a the VIX futures, we see prices that are incredibly low compared to their average over the last few years. Because volatility is so cheap now, the futures market is predicting volatility will normalize in the future, thus, they give a higher value to futures contracts further out.
This is why backwardation can be thought of as traders better prices will normalize higher than they are now.
But Then What About Contango?
If backwardation is futures prices furthest away from expiring are higher than those closest to expiring, what is the opposite of that?
Contango is the prices of future contracts closest to expiring being higher priced than those furthest away. While we currently are not experiencing contango in any futures markets, here is an example of what it would look like.
Imagine a VIX futures image that looks something like this:
- We see /VX23M7 expiring in 2 days for $20.00
- We see /VX24M7 expiring in 9 days for $19.75
- We see /VXM7 expiring in 16 days for $19.00
- We see /VX26M7 expiring in 23 days for $17.00
- We see /VX27N7 expiring in 30 days for $15.85
In the example above, we can see prices closest to expiring are higher priced when compared to those furthest away from expiring.
This is known as contango, and again, is a way to see prices are expected for normalize lower in the long run. A $20 VIX future is very high compared to its average over time, so the market is simply expecting volatility and the price of those /VX futures to come down back to reality as some point in the future.
Contango vs Backwardation...Who Wins?
Well, what do you think?
Think about it...when we speak about contango vs backwardation...who do you think wins?
And let me make it a little more clearer for you...
Who wins? Let's think about it in the terms of the VIX futures. Is price more likely to be lower than the average or above the average?
Above is a chart of the VIX futures for the last 365 days (200 trading days). We see up days in green, down days in red, and a blue line across the middle representing the 200 day moving average for this product. We can call that for arguments sake the average.
So I will ask you again, do you think the VIX futures (volatility) spends more time below its average (backwardation) or more time above its average (contango)?
You got it! More time in backwardation. In fact, it futures contracts are in backwardation about ~80% of the time.
How Do Contango and Backwardation Impact Stocks?
Well I have news for you...they do not impact all stocks, however, they most certainly impact stocks that we are sure you trade almost every single day.
Know those volatility stocks that people love to trade? I'm talking about VXX and UVXY. Those volatility products that you love to get long and keep on scratching your head why you never make any money from them (even if the VIX goes up)?
Before we just lay it on you, let's worth through an example...
Again we see the same image we posted above when speaking about backwardation. Let's do some math, shall we!
If we have 10 futures contracts in the /VX23M7 expiration cycle in which we are long (we own them) and they are about the expire, what do we do? We move those contracts to another cycle that is further away from expiring. Now, 80% of the time, the futures contracts further away from expiring are going to be higher priced than the ones closest to expiring.
Let's do the math. We own 10 /VX23M7 contracts at $10.25, which is a total notional value of $10,250 a contract or $102,500 in total. We have to get rid of those contracts and move them to another month, say the /VXM7 contracts which expire in 16 days.
Those contracts happen to be trading for $11.50 a contract. This we have to sell our contracts for $10.25 and buy another one for $11.50 at the same time. This transaction results in a loss of $1.25 ($1,250) per contract or $12,500 for the entire trade.
That is a massive loss but at the same time a reality for futures traders.
Remember, 80% of the time in order to remain long /VX futures, traders have to take losses to maintain the position.
But what if those two volatility products got their prices from managers holding VIX futures contracts? Wouldn't that mean those managers have to take a loss to keep the contract and the subsequent stock alive?
This is exactly how we get products that are supposed to be priced off of
To look like this...
Again, let me break that down for you...
$VXX get's it price from managers managing long positions of /VX futures. And those futures are in backwardation 80% of the time. When those futures are in backwardation, the managers of the product must take a loss in order to keep the product alive. And when they do, what happens to the price of the product? It goes down...
Yes, you heard that correctly...
If the VIX goes nowhere over the course of the day, VXX will go down because the VIX futures, which is what VXX is priced off of, are in contango 80% of the time.
And 80% of the time, those who manager VXX have to take a loss in order to maintain the product.
What Can I Do Now?
Well for starters, you should never, under any circumstances, get long an ETF or stock that gets its price from a corresponding futures product. That's the first thing you can do.
Again, you do that because you have the odds against you 80% of the time. Those aren't great odds. The times when the odds are on your side (20%) are not four times better.
But what products should we stay away from? Here is a list of some of the products that get their prices from futures contracts.
So we stay away from getting long those ETF...but is there something better we can do? Well, if going long puts the odds against us 80% of the time, maybe we can get short them and put the odds on our side 80% of the time!
Makes perfect logical sense!
Wrapping Up Contango vs Backwardation
That was a lot! Here is what we have covered in this article:
- Futures products are giant products that are used to lock in prices years in advance by commodity producers.
- Backwardation is the back month futures having higher prices than the front month futures and occurs 80% of the time.
- Contango is the front month futures having higher prices than the back month contracts. This happens 20% of the time.
- ETF's that get their prices from futures products (VXX, UVXY, TVIX, etc) have a negative drag against them 80% of the time.
- We never ever for any reason get long these products, however, getting short them allows us to put the odds on our side 80% of the time.
There you have it folks. Contango vs backwardation. It is clear backwardation occurs 80% of the time and we can use that to our advantage. Instead of doing what everyone else does and only buys stock, we can figure out a way to profit from downward movements by getting short these products that have a negative drag against them 80% of the time!