Ultimate Guide To Contango And Backwardation

Understanding Contango and Backwardation

The age-old theme of trading and investing follows the mantra, “Buy low and sell high.” However, there are widely traded and owned exchange-traded-funds (ETFs) that practice the opposite mantra, “Buy high and sell low.” Why on earth would anyone invest in an instrument practicing that type of management 80% of the time? As it turns out, the pricing structure of contango is “normal” for futures but a nightmare of certain types of ETFs.

What is Contango?

Contango, also called forwardation, is the pricing situation found with futures contracts where longer-dated futures consecutively trade at higher prices than the spot (current period) contracts. Usually, time premium and/or carry costs (for commodities) normally makes long-dated (further out) futures more expensive then near-term or current month futures. 

Contango Forwardation Futures Contracts

Equity options follow contango pricing, where long-dated options carry a higher premium than the front month options. Futures markets are in a state of contango approximately 80% of the time. As expiration nears, the futures move closer to the spot price as buyers prepare to take delivery of the underlying commodity to close out the contract. 

What is Backwardation

The opposite of contango is backwardation –  a pricing situation where the spot price trades higher than longer-dated futures contracts. This implies demand for the commodity spiked so hard that it’s worth more now than later as demand falls off. This is also a sign of volatility spikes, which can trigger from demand shock and/or supply disruption.

Backwardation Futures Contracts

In the case of commodities, crude oil futures are normally in a state of contango until a demand/supply shock triggers like a war or geopolitical tensions in the middle east. Crude oil futures have carry costs to store the physical oil which lend to the contango effect. As front month futures near expiration, the future and spot prices overlap as buyers take physical delivery from sellers. Backwardation tends to occur less than 20% of the time with VIX futures. When the COVID-19 pandemic triggered the S&P 500 index ETF (NYSEARCA: SPY) collapsed of (-35%) in five-weeks, VIX trading instruments like UVXY and TVIX went parabolic causing extreme backwardation when the current spot priced higher than the long-dated futures.   

TVIX Parabolic Backwardation

Why Traders Need to Understand Contango and Backwardation

Even if you don’t trade futures contracts, contango could make a material impact if you trade ETFs that trade underlying index of commodity futures. Leveraged ETFs on the VIX, crude oil, gold and even the S&P 500 all fall under contango pricing.

However, certain instruments like VIX products and leveraged ETFs state the objective is to mirror the “one-day performance” of the underlying index or commodity. Usually, this done synthetically buying and selling the futures contracts. In a normal contango market, an ETF will buy the forward month futures while selling the spot or current month contracts to keep an average inventory for a 30-day period. It’s a perpetual process of rolling the futures forward. However, ETFs can’t roll over futures, instead they buy the further out futures at a higher price to replace the current futures being sold at a lower price. This results in decay over time during contango periods. This is why leveraged ETFs like the UVXY tend to lose 8 to 13% monthly during low volatility periods. Long-term investors should never hold these ETFs in a portfolio as the time decay erodes value.

ETFs Time Decay

Impact on ETFs

The effects of extreme contango and backwardation can result in the malfunction and breaking of ETF products. On April 23rd, 2020, investors and traders were witness to an unprecedented event when May crude oil futures went negative the day before expiration sinking to negative (-) $34 per-barrel.

Crude Oil Futures Contract Price

Due to the global demand freeze from the effect of COVID-19 and oversupply, buyers actually refused to take delivery due to the carry costs of storage. In fact, the buyers were paying not to deliver the oil, which is how the contract price went negative. Each contract representing 1,000 barrels of crude oil.

Unfortunately, this disruption caused the widely held United States Oil Fund (NYSEARCA: USO) ETF to collapse and malfunction as extreme contango went into effect. The lasting ripple effect is not only the loss of value, but the loss of confidence in widely held ETF products as investors get a rude awakening to what they were actually holding.

USO ETF Extreme Contango

Conclusion

The takeaway lessons here are traders is to be very cautious holding any leveraged or commodity ETFs beyond a short-term time frame. It also helps to be aware of the underlying mechanics behind how these ETFs mirror the performance of the index or commodity. If futures contracts are involved to take on synthetic positions (rather than owning the actual commodity), then be aware of the embedded value decay and erosive nature of the contango effect.

The information contained herein is intended as informational only and should not be considered as a recommendation of any sort. Every trader has a different risk tolerance and you should consider your own tolerance and financial situation before engaging in day trading. Day trading can result in a total loss of capital. Short selling and margin trading can significantly increase your risk and even result in debt owed to your broker. Please review our day trading risk disclosuremargin disclosure, and trading fees for more information on the risks and fees associated with trading.

Related Content

The Five-Step Process Behind Every Trade

The Five-Step Process Behind Every Trade

On the surface, executing a trade seems as simple as clicking the BUY button and then clicking the SELL button shortly after. Just like the proverbial iceberg theory, only 20% of an iceberg is visible above the surface. The majority of the iceberg is under the...

Adding Liquidity vs. Taking Liquidity

Adding Liquidity vs. Taking Liquidity

The stock market requires both buyers and sellers to operate as an efficient market place. Beginner traders assume there is always a seller on the other side willing to supply shares for sale at the right price and vice versa when they want to sell. Traders usually...

The Ultimate Guide to Using Stochastics

The Ultimate Guide to Using Stochastics

For traders, identifying key price levels ahead of time is part of the preparation that goes into developing a trading game plan. As they say, “Plan your trade and trade your plan.” While many traders do well enough with price charts and trend lines, active traders...

What is NASDAQ Totalview?

What is NASDAQ Totalview?

NASDAQ is the pioneer of electronic trading as it introduced the world to an alternative to the auction style open outcry style of order executions found on the New York Stock Exchange (NYSE). Rather than giving autonomous authority to a single specialist to control...

What is ArcaBook?

What is ArcaBook?

Seasoned traders know that price, liquidity and execution are the cornerstones for the success of any trading strategy and methodology. The stock markets have evolved from open outcry (auction-style) operations with human specialists taking orders to electronic...

Stock Buying Power – The Complete Guide

Stock Buying Power – The Complete Guide

In trading, your stock buying power is your ammo. Regardless of how strong your skill sets are, lack of ammo leaves you without an offense or a defense. Knowledge of your changing intraday buying power is crucial to assessing your risk thresholds and preventing...