Using Volatility Differences to Structure an Earnings Trade

Contango, Backwardation, and Volatility: Implications for Options Trading

Key Concepts:

• Contango: A situation in futures markets where the futures price is higher than the spot price, and further-dated futures contracts are priced higher than nearer-dated ones.
• Backwardation: A situation in futures markets where the futures price is lower than the spot price, and nearer-dated futures contracts are priced higher than further-dated ones.
• Cost of Carry: The costs associated with storing and financing an asset until its delivery date (relevant to contango/backwardation in bonds).
• Implied Volatility (IV): A forward-looking measure of expected price fluctuations of an underlying asset, derived from option prices.
• VIX: The CBOE Volatility Index, a real-time market index representing the market's expectation of 30-day volatility.
• Iron Condor: An options strategy involving the sale of an out-of-the-money call spread and an out-of-the-money put spread.
• P50: Probability of achieving at least 50% of the maximum potential profit from a trade.
• Delta: A measure of an option's price sensitivity to changes in the underlying asset's price.

Understanding Contango and Backwardation in Futures and Volatility

The discussion begins with clarifying the distinction between contango and backwardation in futures markets versus their application to volatility. Contango specifically refers to a situation where front-month futures contracts are priced lower than back-month contracts. Conversely, backwardation occurs when front-month contracts are priced higher than back-month contracts.

Examples are provided using soybeans (Z.S) and bonds (ZB). Soybeans currently exhibit a mix of contango in the front months and backwardation in the back months (March in contango, May/July in backwardation). Bonds show a narrower contango/backwardation spread. The key takeaway is that in commodities like soybeans, these patterns can signal supply and demand imbalances – a sharp move into backwardation potentially indicating a short-term shortage, while contango might suggest future supply concerns.

However, in financial instruments like bonds or S&P 500 futures, contango/backwardation are primarily driven by the cost of carry – the difference between interest rates and dividends/yields. Therefore, these patterns don’t necessarily provide directional insights.

Volatility and the Relationship to Contango/Backwardation

The conversation shifts to how these concepts relate to volatility, particularly in options markets. Backwardation in volatility manifests as higher implied volatility in front-month options compared to back-month options. This often occurs during market crashes when the VIX spikes. The expectation is that heightened volatility is unlikely to persist long-term, leading to lower IV in later-dated options.

A key point is made: “Backwardation is if we see a like a crash in the market and VIX explodes we go into backwardation where our front month options have a higher V than our backmonth options.”

Actionable Strategies: Trading Volatility Skews

The core of the discussion revolves around whether these patterns can be exploited for trading profits. The consensus is that directly speculating on contango or backwardation in futures isn’t particularly profitable; it’s primarily informational. However, the volatility skew created by backwardation can be leveraged.

Specifically, when backwardation is present (high front-month IV, lower back-month IV), the speakers suggest considering selling shorter-term options. The rationale is that the market is overpricing short-term volatility, and as it normalizes, the options will lose value.

“...when we're getting such an increase in volume in those shorter term options it might be beneficial to to bring your strikes in sell higher deltas sell slightly shorter term options then go to the 16 delta 45 days…”

Case Study: Nvidia (NVDA) and Earnings Trades

The discussion illustrates this concept with a real-time example using Nvidia (NVDA) leading up to its earnings announcement. The speakers observe a significant increase in implied volatility for near-term options (3-day, 7-day) compared to longer-dated options, directly attributable to the earnings event.

They demonstrate how this volatility skew can be used to construct an iron condor option strategy. An iron condor involves selling out-of-the-money call and put spreads, profiting from limited price movement. The higher volatility in the short-term options allows for a larger premium to be collected.

The Importance of the P50 Metric

A crucial element of their trading approach is the use of the "P50" metric – the probability of achieving at least 50% of the maximum potential profit from the trade. This helps assess the risk-reward profile and determine an appropriate exit point.

“...if I can sell that iron condor for a buck 58, half the max profit is what about I don't know uh 80 cents or so. Let's say 75, If I have about a 66% probability, pretty good, of taking that trade off for a 50% profit before earnings…”

They emphasize that if the trade’s probability of reaching 50% profit drops (e.g., to 66%), they would consider closing it for a smaller profit, even before expiration.

The Practical Application of Theoretical Concepts

The speakers underscore the importance of translating theoretical knowledge into actionable trading strategies. They emphasize that understanding contango and backwardation is valuable, but only if it can be used to generate profitable trades.

As stated by one of the speakers: “So my point is all this discussion is very interesting but if I can't turn it into a trade okay it's a nice to know thing.”

Conclusion:

This discussion highlights the nuanced relationship between contango, backwardation, volatility, and options trading. While contango/backwardation in futures markets can provide insights into supply and demand (commodities) or cost of carry (bonds), the real trading opportunity lies in exploiting the volatility skews created by backwardation in options. By strategically selling short-term options when volatility is elevated, traders can potentially profit from the eventual normalization of volatility, while carefully managing risk using metrics like the P50 probability. The key takeaway is that theoretical understanding must be coupled with practical application and a disciplined approach to risk management.