Contango and backwardation options. Ultimate Guide To Contango And Backwardation
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- Understanding 'Contango' and 'Backwardation'
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- Ultimate Guide To Contango And Backwardation
- What Is Contango and What Does a Contango Market Tell Us?
- Upcoming Events
- Contango or Backwardation: Looking to the Future in the Futures Markets
- Forward and futures contracts
- What Is Backwardation and What Does a “Backwardated” Market Tell Us?
Dan Keegan Founder, Optionthinker.
Understanding the forward price curve of individual markets — particularly commodity markets — is an important aspect of understanding market drivers. The forward price curve provides clues as to how market participants — especially commercial entities who either need the underlying commodity or work in the production chain of that underlying market — view the fundamentals of that market.
Understanding 'Contango' and 'Backwardation'
To understand the underlying fundamental market dynamics, traders and investors need to understand the concepts of contango, backwardation and skew. When a market is in contango, that means that the forward price of the futures contract is higher than the spot price.
When the market is in backwardation, that means that the forward price of the futures contract is lower than the spot price.
The premium above the current spot price for a particular expiration date is usually associated with the cost of carry. With commodities, the cost of carry generally includes storage costs and interest.
Many traders see opportunities for reversion to the mean trades created by contango and backwardation conditions. If the spot price is trading at an unusually low level the expectation is that it will rise in price at some point.
Ultimate Guide To Contango And Backwardation
If contango and backwardation options spot price is trading at a price far above the norm then the expectation is that it will drop in price some time in the future. As the futures contract approaches settlement, there is a convergence between the futures price and the spot price. Further out contracts typically reflect broad long-term supply and demand fundamentals of a market, whereas near-term contracts are more effected by short anomalies based on things like weather.
Except for the harvest month of September, they are all climbing but less than the cash market.
What Is Contango and What Does a Contango Market Tell Us?
It represents the cost of carry. Spot VIX declined Each monthly futures contract from September through February was consistently higher. The VIX was at a relatively low level so contango made sense. SPY was crashing with the rise in interest rates. Each monthly futures contango and backwardation options from January through June was consistently lower.
The VIX was at an abnormally high level so backwardation made sense. When trading a volatility futures contract like VIX or an agricultural contract like soybeans, a reversion to the norm makes sense. The same is true with the VIX.
We need to first look at historical volatility. That would mean that the historical volatility is Implied volatility is a reverse engineering process where the current pricing of options indicates the future trading range of the underlying value. Both the calls and puts are trading at 4. The implied volatility is SPY is priced at The Jun.
If there was a normal distribution the implied volatility would be the same for every strike price.
There is, however, an asymmetric distribution. The puts and the calls are equidistant from the price of SPY, yet the time value in the puts is more than eight times the time value of the calls.
Contango or Backwardation: Looking to the Future in the Futures Markets
This is because SPY typically moves to the downside much more rapidly than it does to the upside. It also could be because there are restrictions to outright shorting individual equities so there is a greater demand to hedge against moves to the downside than to the upside.
Since options are wasting assets the puts are more likely to come into play than the calls. That justifies the greater amount of time value that is embedded in their premium.
Forward and futures contracts
Profiting on Skewness How can we profit from this knowledge? If the VIX is at an extremely high level, then it is likely to revert to the downside.
You are net short time value so any decrease will be profitable. You would want to make this trade at a time of backwardation.
What Is Backwardation and What Does a “Backwardated” Market Tell Us?
You could buy 30 June puts with delta and sell 20 puts with a delta. You would benefit from a pop in implied volatility.
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- Contango vs. Normal Backwardation: What's the Difference?
You would only do this in a time of extreme contango. Understanding the properties of contango, backwardation and skew is key to understanding the pricing function of options, and the ability to recognize opportunities when that pricing appears to be out of whack. Dan Keegan, founder of optionthinker. You can reach Dan at dan optionthinker.