An answer I gave on Quantopian.
Thanks Anthony. I knew something was off, just not what it was. Can you please explain just for my edification what exactly continuous futures are and why they are different?
You can NOT use a “normally” back adjusted futures contract to back test XIV if that is what you are trying to do. Nor indeed to calculate historic contango/backwardation. You need individual contracts. And so far as testing XIV is concerned you need to form an index of daily price returns. The real trick is to ensure that on the roll date the daily return is that of the old contract / new contract so you capture the contango or backwardation. Almost any other method will distort the calculated price series .
Jeez….it’s a bloody big topic. Send me a message via my website with your email address and I’ll send you a spreadsheet as to how I calculate the index for a continuous futures contract.
It just entails stringing together individual futures contracts so that you can back test. In general it’s not a great idea to use conventional back adjusting methods. I prefer to create an index in the way my spreadsheet will show.
As to concatenating futures contracts and the general methods used you might take a look at:
The disadvantage of my method of course is that you can’t see the prices. But it forms a more accurate picture of what you would gain or lose over time.
The real nub of it is filling the gaps created by contango and backwardation when there is a gap between the expiry price of one contract and the price of the next. Much of the money is made by the roll rather than the price movement or trend. This is why the vix is such a profitable trade if you get the timing right. You are just hauling in the contango or insurance premium 80% of the time and running like hell when it goes wrong!