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Contango and its use (1/2)

23 Nov 2017,

In the last two parts of my series, I have shown you why I consider VIX and its derivatives as a very interesting source for generating alpha. In today’s article, I would like to focus more on the first condition, i.e. high contango. So, let me explain what the contango is all about and what does it mean when the market is in contango.

Contango is a situation where the spot price is below the prices of the next futures contracts. On the contrary, backwardation occurs when current prices on the physical market are higher than the prices of next futures contracts.

On the picture below, we can see the term curve of the futures contracts for VIX volatility index, which is often referred to as a “barometer of fear” for its market behaviour. I do not want to bother you with too much theory, however in any case it is good to understand at least the basis of its calculation. The VIX index is calculated based on the 30-day implicit (expected) volatility of the S & P 500 stock index, better said from its closest and farthest call and put options. The value of these options therefore affects the VIX index value.

Simply put, the bigger is the expected future volatility and nervousness in the markets, the bigger is the need of investors and portfolio managers to ensure themselves. As you know, one of the ways how to secure a portfolio against decline is to purchase securing put options. In such exhausted situation, there will be an increased demand for put options, and this will increase their value, and the growth is therefore transferred to the calculation of the VIX index.

 

Termínová křivka VIX futures

Figure 1: VIX futures term curve (source: spreadcharts.com)

 

Thus, from today’s point of view, it is obvious that the market is now in contango, the term curve is growing, which is fairly typical for the VIX futures market. It can be simply interpreted. The longer is the time investors want to secure their portfolios for, the more they have to pay for such securing.

It can be easily compared to a situation with classic insurance such for a car or a house. You will, of course, pay a higher price for one-year insurance than for a quarter a year.

The opposite of contango is called backwardation– the term curve has – at least in its part – a descending character. This is typical for situations where the market is dominated by huge nervousness, often with significant drops or significant corrections on the stock market. The value of a closer futures contract – i.e., closer securing (e.g. one month) – is therefore more expensive than more distant securing- i.e. the value of the futures contract with a maturity up to one year. E.g. during the fall of 2008 or 2012, the market was in a very strong backwardation.

For most of the time, the market moves in contango, which is documented by the following histogram, which shows the rate of contango distribution (between the nearest and following VIX futures contract). The frequency columns on the right side from the lightly blue colored column show the market in the contango, on the left side, you can see the backwardation.

Contango histogram

Figure 2: Contango histogram – VIX futures (Source: spreadcharts.com)

 

The development of contango/backwardation can be clearly seen from the following graph. Values ​​above zero represent contango, values ​​below zero backwardation. Again, this is the difference between the closest and the next VIX futures contract.

 

Vývoj contanga na VIX futures

Figure 3: Contango Development on VIX Futures (Source: spreadcharts.com)

 

Histogram and charts for the development of contango / bakwardation can be found very clearly and completely free of charge, for example, on the server spreadcharts.com, of course not only for VIX futures but also for other commodity markets as well.

 

 

Back to VIX

From the picture of the VIX index long-term development, we can see that the index tends to be strongly strengthen in the excited situations and panic on the market, often up to very extreme values ​​(eg in 2008 up to 90), but it is, in most cases, under the value 20, especially in recent years, when there is an unprecedented peace on the market. As an imaginary low, we can mark a value of around 10.

 

Vývoj indexu VIX od roku 2000 Development of the VIX Index since 2000 (source: finance.yahoo.com)

 

Looking at the graph of the VIX index itself, you might think about something else – that in a situation where the index reaches a low value, for example between 10-12, it may be the ideal time to enter a long-term buying position and it is only a matter of time when the index jumps to some extreme value and you make an interesting profit.

Here I have to disappoint you. The VIX index itself cannot be traded – practically it is just a calculated volatility spot value. The good news, however, is that other derivatives – futures and options – which are used by a variety of ETFs and other financial products (eg ETN …), are derived from its value, and of course all of these instruments can be traded.

These instruments (volatile ETF / ETN) are usually traded in the same way as classic stocks; for most of them, there is no problem with liquidity and low required capital (they can be traded theoretically from 1 pc as well as the shares). This ETF can also be very comfortably traded through options. A typical representative of this volatile ETF / ETN category is VXX.

In the next chapter, I will introduce you in detail how ETF / ETNs work and how they can be used for interesting trading strategies.

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