The Impact of Contango and Backwardation on Roll Costs
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Introduction
The terms "contango" and "backwardation" describe the shape of the futures curve, and they have a profound impact on the cost of rolling a futures position. A professional trader must have a deep understanding of these market states to effectively manage their roll costs and overall profitability. This article will explore the concepts of contango and backwardation, their impact on the futures roll, and how traders can navigate these market conditions.
Defining Contango and Backwardation
Contango is a market condition where the price of a futures contract is higher than the spot price of the underlying asset. In a contango market, the futures curve is upward sloping, with each successive contract month trading at a higher price than the previous one.
Backwardation is the opposite of contango. It is a market condition where the price of a futures contract is lower than the spot price of the underlying asset. In a backwardated market, the futures curve is downward sloping, with each successive contract month trading at a lower price than the previous one.
The Impact on Roll Costs
The shape of the futures curve has a direct and significant impact on the cost of rolling a futures position.
Rolling in a Contango Market:
When a trader rolls a long position in a contango market, they are selling the expiring contract at a lower price and buying the new contract at a higher price. This results in a negative roll yield, or a "cost" to the trader. The formula for the roll yield in a contango market is:
Roll Yield = (Price of New Contract - Price of Old Contract) / Price of Old Contract
Since the price of the new contract is higher than the price of the old contract, the roll yield will be negative.
Rolling in a Backwardated Market:
When a trader rolls a long position in a backwardated market, they are selling the expiring contract at a higher price and buying the new contract at a lower price. This results in a positive roll yield, or a "profit" to the trader. The formula for the roll yield in a backwardated market is the same, but the result will be positive.
Contango, Backwardation, and the Cost of Carry
The shape of the futures curve is ultimately determined by the cost of carry. In a normal market, the futures price should be higher than the spot price to account for the costs of holding the underlying asset (storage, insurance, financing). This results in a contango market.
However, if there is a significant convenience yield for holding the underlying asset, the futures price can be lower than the spot price. The convenience yield represents the benefit of holding the physical asset, such as the ability to meet unexpected demand. When the convenience yield is high enough to offset the other costs of carry, the market will be in backwardation.
Data Table: Hypothetical Roll Costs
The following table illustrates the impact of contango and backwardation on roll costs for a long position in the E-mini S&P 500 futures:
| Market State | March ES Price | June ES Price | Roll Spread | Roll Yield |
|---|---|---|---|---|
| Contango | 4,000 | 4,020 | +20 | -0.50% |
| Backwardation | 4,000 | 3,980 | -20 | +0.50% |
Actionable Examples
Example 1: Commodity Futures
A trader is long a crude oil futures contract. The crude oil market is in a steep contango due to high storage costs and a surplus of supply. When the trader rolls their position, they will incur a significant roll cost. The trader might consider reducing their position size or using a different strategy to mitigate the impact of the negative roll yield.
Example 2: VIX Futures
The VIX futures market is often in backwardation, especially during periods of high market volatility. A trader who is short VIX futures will benefit from a positive roll yield as they roll their position. This can be a significant source of profit for short volatility strategies.
Conclusion
Contango and backwardation are fundamental concepts in futures trading, and they have a direct and significant impact on the cost of rolling a futures position. A professional trader must be able to identify the current market state, understand its implications for their roll costs, and adjust their strategy accordingly. By mastering these concepts, traders can improve their profitability and more effectively manage their risk.