Coronavirus Sends VIX Into Backwardation—Here’s What That Means

(Bloomberg) -- Usually when “contango” comes up in a markets story, one reaction might be “Huh?” while another might be “Where’s my oil tanker?” That’s because contango and its sister term, backwardation, are used most often in the context of futures markets for commodities. But they can pop up in any derivatives market and during turmoil driven by the spread of the coronavirus, volatility futures have, unusually and perhaps alarmingly, slipped from contango into backwardation. Here’s how to understand what that means and why traders care.

1. What are contango and backwardation?

Names for curve structures that map traders’ guesses about what a given contract will be worth in the future. Contango means upward sloping; backwardation, downward. In the oil markets, that means that if traders will pay more to lock in a shipment at a given price several months away than they would for delivery next month, the market’s in contango.

2. What does that mean for volatility?

The Cboe Volatility Index, or VIX, as it’s known, is compiled based on the current state of trading in options -- contracts giving the right to buy or sell securities at specified prices in certain conditions. Traders often use these derivatives to hedge against market fluctuations. The VIX uses options prices for equities -- the amounts traders are willing to pay to be prepared for different outcomes -- to calculate what’s called the implied volatility for the S&P 500 Index.

3. Where is the VIX curve usually?

In contango. That’s because projections about the outlook for the S&P, like for the weather, normally become more uncertain the further into the future one looks. The VIX futures curve is based on options, and longer-dated options generally have more value than shorter-term ones.

4. What’s happening now?

The VIX futures curve is in backwardation. That’s a signal that investors expect more volatility in the near-term, as the world grapples with what the spread of the virus means for the global economy. Right now, shorter-term contracts are more expensive than longer ones. What’s particularly unusual about the current inversion is how deep it is beyond just the first two contracts, for March and April. The spread between the second and third-month futures contracts is at one of its widest levels during this bull market. Performance during other similar instances, like the markets’ reaction to China’s devaluation of the yuan in August 2015 as well as the debt ceiling drama and European debt crisis in 2011, suggest that it may take quite some time to digest the risks investors are grappling with at present.

5. What does that mean?

That market participants are preoccupied with the risk that’s right in front of their faces. That’s shown no signs of abating, with stocks on track for their worst week since 2011 as the spread between short and longer-term contracts became increasingly negative. Any narrowing of the gap, let alone a return to contango, would be a sign that conditions are normalizing.

6. Where do those terms come from?

That’s hard to say. But they’ve been around for a while. In Gilbert and Sullivan’s penultimate opera, “Utopia, Limited,” in 1893, a corporate shill is introduced with this: “A Company Promoter this with special education/Which teaches what Contango means and also Backwardation.”

7. And what was that about oil tankers?

Remember how that futures price curve is sloping upward in contango? If the oil traders are right, they can make money by buying oil at today’s spot price, selling a futures contract for delivery at the higher price expected in the future and storing the oil in the meantime. After oil prices crashed with the financial crisis of 2008, investors put 90 million barrels of crude into floating storage.

To contact the reporters on this story: Luke Kawa in New York at lkawa@bloomberg.net;Hailey Waller in New York at hwaller@bloomberg.net

To contact the editor responsible for this story: Jeremy Herron at jherron8@bloomberg.net

©2020 Bloomberg L.P.