Contango and Backwardation
Contango and backwardation are two concepts related to futures contracts that need to be understood in VIX trading
Contango and backwardation are two concepts related to futures contracts that need to be understood in VIX trading because VIX ETFs buy or sell some combination of futures contracts.
XIV sells short the first two front months of the VIX futures contract and VXX buys the first two front months and so both are affected by contango and backwardation.
Contango simply means that futures contracts that are farther out in time are more expensive than the current price of the index and backwardation means that future months are cheaper than current prices.
In VIX futures, the typical configuration is contango in which farther out months are more expensive and this will impact VIX ETN investors in either a positive or negative way.
chart courtesy of vixcentral.com
In the chart above, we see a period of backwardation from September through December and then a return to contango which is the normal configuration of the VIX term structure.
During backwardation periods, NYSEARCA:VXX will have a build in advantage while during times of contango, XIV will have a built in edge.
For investors in NYSEARCA:VXX, contango is a bad thing as the ETN continually buys contracts that are more expensive going forward that then over time decline to the current spot price.
Effectively speaking, NYSEARCA:VXX is continually buying high and selling low.
On the other side of the question, NASDAQ:XIV is selling higher priced contracts when VIX is in contango and then buys them back at a lower price near expiration and so effectively buys low and sells high on a daily basis.
When contango is in effect, the futures contracts of the front two months will decline towards the spot price, effectively boosting the price of NASDAQ:XIV and causing NYSEARCA:VXX to decline.
When backwardation is in effect, the opposite forces are in play, supporting NYSEARCA:VXX prices and hindering NASDAQ:XIV prices.
Why Contango And Backwardation Matter
As we've discussed, contango is the normal state of the affairs in the VIX futures markets. Each succeeding futures month is more expensive and this means that S&P investors are expecting volatility to decline and the S&P 500 index to climb over time.
Some investors and traders even use contango and backwardation as a timing indicator and TradingGods.net incorporates contango and backwardation into our trading decisions.
While not perfect or precise, when VIX is in contango, the S&P 500 is typically in bullish configuration and long equity positions would be more likely to succeed. Also for volatility traders, inverse volatility issues like NASDAQ:XIV would be most appropriate.
When backwardation is in effect, a massive body of traders expects volatility to increase and S&P 500 index to fall and so this would potentially be bearish for the S&P 500 and bullish for long VIX trades.
VIX tends to average around 20 and so one can also make an assessment of the market's condition in relation to VIX price compared to its average. VIX above 20 would indicate a volatile market with bearish like properties for the S&P 500 while below 20 would indicate normal market conditions and even complacency as the index drifts into the teens.
For VIX volatility products, contango can generate automatic gains for NASDAQ:XIV as it shorts the second month futures contract and covers the front month's futures contract every day. This provides an automatic tailwind for NASDAQ:XIV even is the S&P 500 or VIX index are flat on the day. NYSEARCA:VXX traders experience the opposite effect as NYSEARCA:VXX buys the second month's futures, which are more expensive and sells the front month's futures every day.
But one cannot count on backwardation or contango to ensure gains as VIX will move violently up or down in response to moves on the S&P 500.