Contango and Backwardation in Volatility Futures
Contango and Backwardation in Volatility Futures
Contango is when future volatility is greater than spot volatility, and backwardation is the opposite
By focusing on volatility, we find directionless opportunities in markets that are moving rapidly.
The default setting in volatility is Contango, where future volatility sells for more than spot volatility.
Sometimes, especially after rapid volatility expansions, volatility can move into Backwardation—where spot volatility is greater than future volatility.
We love trading volatility. Instead of trying to time the market and pick direction, focusing on volatility frees us to take nondirectional approach. That’s why we always keep an eye on volatility to find new trade entries and exploit opportunities.
A big part of this process lies in the relationship between VIX and /VX.
Status quo: Contango
Normally, the relationship between current, or spot, volatility (VIX) and future volatility (/VX) is one where the future volatility is greater than spot volatility—a relationship more commonly referred to as Contango in the futures world.
Contango as a default setting not only makes mathematical sense but also intuitive sense. Given that there is always an added layer of uncertainty when you’re dealing with a longer segment of time, the expectation of future volatility should be greater than current volatility.
Therefore, Contango in volatility is what we observe 85%-90% of the time.
Far less common: Backwardation
But sometimes, volatility can actually slip out of Contango and enter what is known as Backwardation. This is where spot volatility is greater than future volatility, and this is what the market has been experiencing this entire week.
Here, active investors are betting on the future being less volatile than the present, even given the added uncertainty and unknowns of more time. Backwardation in volatility typically occurs only after an extreme expansion in volatility. So in essence, the current chaos in the market is so great that everyone see calm on the horizon instead of continued craziness.
When volatility does expand rapidly, it doesn’t typically stay extremely elevated for too long. Because the VIX is based on SPY options prices, it needs a constant flow of new demand for options to remain high.
Once that flow of demand dries up, and active investors begin to sell the options they had purchased that sent the VIX skyrocketing, volatility can collapse quickly. When that happens, it’s only a matter of time before the Contango in volatility is restored.
Jim Schultz, a quantitative expert and finance Ph.D., has been trading the markets for nearly two decades. He hosts From Theory to Practice, Monday-Friday on tastylive, where he explains theoretical trading concepts and provides a practical application of those concepts to a trading portfolio. @jschultzf3
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