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To successfully trade volatility one needs to have a thorough understanding of the concepts of Contango and Backwardation. In the first article of this series I went over the basics of both concepts and today we will be delving deeper into Contango to provide a broader understanding.

Contango is a state in the Futures market when the forward month futures contracts are at a higher price than the current or spot price. For short term volatility, which is in Contango the majority (~70%) of the time, it will look something like this:

Spot VIX: 18.00

1 Month Out Futures: 20.00

2 Months Out Futures: 22.00

You will notice that 1 month and 2 month out futures are higher than the spot price. With this being the case, the Volatility Index futures are in Contango.

If the prices were reversed:

Spot VIX: 22.00

1 Month Out Futures: 20.00

2 Months Out Futures: 18.00

The Volatility Index futures would be in Backwardation.

While Contango is simply the inverse of Backwardation, and vice versa, it is imperative that we understand what Contango is and what it does to volatility products over time.

Knowing Is More Than Half the Battle

We've established that Contango is a state in which future month contracts are higher than the current but it can also be stated as the market expecting larger market movements in the future than are occurring currently. Since uncertainty of the future is ever present, there is usually an expectation that the markets will be more volatile in the future, unless current conditions have reached crisis levels.

Since all volatility products trade based on the performance of selected VIX futures products, there is never a straight correlation between spot VIX and short term volatility ETFs/ETNs like VXX, XIV, SVXY, UVXY and TVIX. Each of these products are managed using the front month and next month futures contracts. The institution that provides these trading devices buys VIX contracts over time to match the performance in the futures market. At any point in time, they will be mirroring a mix of front month and next month contracts.

As we get closer to the expiration date of the front month contract (Always on a Tuesday) the volatility products will be selling their front month contracts and buying the next month contracts to maintain their objective of representing short term volatility. The volatility products are continually trading in the futures market and rolling their contracts as time passes to the next monthly contract.

To simplify things, once the August VIX futures contract expires on Tuesday, August 21, all of the short term volatility products will be comprised 100% of September Futures contracts. As we head towards the September futures contract expiration date of Tuesday, September 18th, the mix will go from 100% September contracts to X% September and Y% October with Y reaching 100% when the September contract expires.

Day after day, month after month these products roll over to new contracts and any price differences between the monthly futures will affect their nominal performance.

Infinitely Falling Knives

To put it in a way that is easier to visualize, let's see what Contango does over time (Holding VIX and the term structure constant for simplicity. You want more variables, be my guest).

Spot VIX: 18.00

September Futures: 20.00

October Futures: 22.00

Difference between Sep/Oct Futures: 10%

Trading Days between Sep/Oct Expiration: 20

As the days pass, the proprietor of the fund will be selling September contracts and buying October contracts. Forced to sell 5% of the Sep Futures at 20 to buy Oct Futures at 22, there is a daily loss of ~0.5% as the contracts are rolled to the next month.

Remember, we are keeping VIX and the Futures contracts at a constant level, so even with absolutely no movement in the market, anyone holding long VXX would lose ~10% (in this scenario) between September and October expiration due to Contango and the cost of rolling to the next month contract.

Since this occurs over time and daily losses "compound" differently than a one time loss, the movement in VXX and UVXY would resemble this pattern:

Contango In Action

You'll notice that even though there is a 10% difference between the two contracts, implying a 10% loss due to Contango, the loss in VXX and UVXY does not exactly match it. This is a function of logarithmic mathematics and is the reason you see the statement "this product will head to zero" whenever you read a prospectus for a volatility product.

Since the VIX futures market is in Contango 70% of the time, there is a natural tendency for long volatility products to trend downward, even in flat markets, due to the roll of contracts from month to month. With that in mind, it is imperative that one realizes that long term holdings in VXX, UVXY and TVIX are not viable and anyone trading volatility needs to be willing to "cut and run" to preserve capital in a losing trade. There will always be some level of volatility in the markets and as such there will always be more chances to trade. Don't be stubborn and don't be greedy and you'll be able to survive long enough to capitalize on any future opportunities.

Contango is a key point that anyone trading volatility needs to fully understand and hope that I have shed some light on what it means for those playing in the volatility markets. In the next installment of this series, we will be taking a closer look at Fantasy Land for long volatility holders, otherwise known as Backwardation.

Source: So You Want To Trade Volatility: Understanding Contango