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Contango & Backwardation

Contango

Contango is a term used to describe a situation where prices for future products are higher than their current prices. As a result, there is an upward-sloping curve on the term structure. This is considered a normal market and is most commonly observed in commodities.


The concept of contango can apply to the implied volatility of stocks and most certainly to VIX futures. If the expected volatility for distant future periods is increasing, it mirrors the contango idea.


Contango essentially reflects optimism about the future, as participants are required to pay a premium to secure goods for future delivery. It is indicative of an expectation of rising prices or increased demand in the future. This positive outlook can stem from a variety of factors, such as expected economic growth, favorable supply-demand dynamics, or improved market conditions.



In a contango market, front-month futures contracts may be cheaper, but participants still often opt for longer-dated contracts to hedge against anticipated future price increases or to align with operational needs and risk management strategies.


Backwardation (Inverted Market)

In contrast, there's a term called backwardation. This is a situation where prices for future products are lower than their current prices. It arises when the future price of a product is lower than its current price, creating a downward-sloping curve on the term structure.


In the context of commodities, backwardation can be understood as a reflection of immediate scarcity or urgency. Participants are willing to pay higher prices for immediate access to goods or assets, suggesting that they perceive potential risks or disruptions in the future. This cautious outlook might stem from factors such as geopolitical tensions, economic uncertainties, or supply and demand disruptions.


Similarly, the concept of backwardation can be applied to the implied volatility of stocks and most certainly to VIX futures. If the expected volatility for future periods is lower than the current price, it mirrors the backwardation idea.


This could reflect heightened uncertainty and the anticipation of significant price swings in the short term. It's important to note that this perceived advantage might be influenced by seasonal or temporary factors that rightfully explain the price variations.


If you would like to learn more about the pricing of futures products, attached is a lesson from the Canadian Securities Institute that delves further into topics such as basis, convenience yield, and various arbitrage strategies.


Chapter_3_-_Pricing_of_Futures_Contracts
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