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I’ve been referring to this contango in a number of recent posts already. Given the recent move last Friday (see my last post over the recent breakout), I thought it worthwhile to write on what it might mean with a practical example.

This is only an illustration of the varying VIX sentiment out there at the moment. I would not view Friday’s move, yet, as a truly significant determinant of the overall VIX curve. At this stage, it remains a bit of a healthy price back. There is a lot of news still to come through over the coming few months that may give more substance to the contango or, conversely, might reduce its value as well. My next few posts should give a few more insights into this curve and relevant events to watch out for.

Contango Hedging

Alright, so when a contango forms, the market in theory is only performing its natural function of adding the risk-weighted value of time into the far future over the underlying contract. That being said, there can be moves that outweigh this natural time-value and instead indicate either an expectation or a supply/demand imbalance over a particular future facet of the underlying. For option traders, this is often done by isolating the Theta and Rho derivatives and seeing whether price gains are outpacing the contribution of these two Greeks. For future traders, this can be implicitly priced into a relative strip position where far futures are hedged against nearer term futures. Most of the time, this should isolate the relative basis and credit facets of a position and produce a rent apportioned to the position’s capital outlay.

Now, as mentioned before, there are times when this contango can go beyond natural expectations, at which point a relative arb should be available to extract by taking an inverse hedge position: short the far future and long the near future in order to extract the relative expectation of a price move. Technically, if you are really confident or have a higher risk-profile, then you should be able to get the same risk-adjusted return by taking a straight long outright position over an outright future.

Results From Friday

Just as an illustration: last Friday produced a bit of a move over the VIX allowing a quick view into this process for a one contract nominal. I’ve shown below the two different trades: one on a straight outright and the other on a hedged exposure short over May and April and long over February and March. The first trade is essentially un-hedged and the latter is actually a straight hedge with zero-naked exposure (I know, I’m keeping it a bit too simple with the single balance nominal here, technically you would need to weight the positions accordingly to match back with the desired exposure).

Contango VIX trade for 28/01/2011

Contango Trade For 28/01/2011: CBOE VIX

Now, as I mentioned in my last post, we are only beginning 2011 so the future is still there to be built upon. Fundamentals are strong at the moment but this does not, none the less, remove the potential for some moves along the curve.

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