A key to understanding market pricing and what opportunities it reveals, is understanding contango, backwardation and skew, notes Dan Keegan.
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.
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. Cost of carry can relates to the costs the commercial interest would need to pay to hold the asset over a period of time. 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. If the 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.
Basic Backwardation
In February 2020 the cash market in corn is at $3.975. The March 2020, July 2020, September 2020 and December 2020 futures are trading at $3.795, $3.895, $3.8725 and $3.905 respectively.
Except for the harvest month of September, they are all climbing but less than the cash market. That’s a simple example of backwardation. It represents the cost of carry.
More Complex Example
Let’s look at futures on the Cboe Volatility Index (VIX) from Sept. 7 to Sept. 14 in 2018. The SPDR S&P 500 ETF Trust (SPY) was steadily rising with a 1.1% increase over those seven days. Spot VIX declined 18.8%. Each monthly futures contract from September through February was consistently higher. The VIX was at a relatively low level so contango made sense.
Let’s look at VIX futures from Dec. 21 through Dec. 28 in 2018. SPY was crashing with the rise in interest rates. On Christmas Eve the SPY hit a low of 234.3 with the VIX closing at 36.1. Each monthly futures contract 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. Soybeans aren’t going to zero or $200. The same is true with the VIX. The VIX measures the premium level of S&P 500 options contracts. Individual stocks don’t always revert to the norm, however. Some stocks do go to zero or go up 10,000%.
Skewness
Now, let’s look at skewness. We need to first look at historical volatility. Let’s say that that XYZ stock traded between $90 and $110 two-thirds of the time. That would mean that the historical volatility is 10.00. If it traded between $70 and $130 the historical volatility would be 30.00 (measuring the distance from the mean price). 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 4.50 in the Feb. 21, 2020 SPY 328 strike price. This predicts a range between $319 and $337 over the next 39 days. The implied volatility is 10.03. If the range turns out to be between $319-$337 during the 39-day time period, the historical volatility will then be 10.03.
Okay, now let’s compare the implied volatility of different options with the same underlying value and the same expiration cycle. SPY is priced at 327.50. The Jun. 19, 2020 365 calls are trading at 0.42 with an implied volatility of 9.38%. The Jun. 19, 2020 290 puts are trading at 3.55 with an implied volatility of 20.10%. The Jun. 19, 2020 328 calls have an implied volatility of 12.47%. If there was a normal distribution the implied volatility would be the same for every strike price.
There is, however, an asymmetric distribution. The 290 puts and the 365 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. 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.
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 could buy 20 June 342 calls in SPY with a 30 delta and sell 20 June 348 calls with a 20 delta. You are net short time value so any decrease will be profitable. You would want to make this trade at a time of backwardation. You could buy 30 June 300 puts with -20 delta and sell 20 313 puts with a -30 delta. You would benefit from a pop in implied volatility. 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.com, operates a six-month one-on-one mentoring program, which brings expertise to new options traders. You can reach Dan at dan@optionthinker.com
