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Judging by the CBOE website, there is considerable interest in the term structure of VIX futures measured as the difference between near term and further out futures on the VIX and also the realtionship of futures to the cash VIX. This can be a premium (contango) or discount backwardization. In fact there seems to be dispute even as to how to interpret that curve as the market predictor of future volatility.

A presentation on this subject on the CBOE website shows a contrasting view of option expert and author Lawrence McMillan who sees an upward sloping curve as a portent of high future volatility and that of "traders" who hold the opposite view. Based on my observation of market data, my experience in the currency options market and my inclination to follow the money rather than the analysis on paper I go with the view of the traders.

My reasoning is as follows. First off, it is important to know that the VIX itself is not a commodity that can be traded. It is really what I would call a "plug number" or the calculated implied volatilty of the near dated S&P options. Without getting into a detailed explanation of the calculation (you can find that here) suffice it to say that if one knows the price of the option, the strike price of the option, the days to maturity and short term interest rates, one can calculate the "implied volatility of options." Since professional market makers in options can (with limitations) change the directional exposure of any option through reversals and conversions they are trading implied volatility.

The enemy of an option holder is a dead market. If the market is devoid of volatility, the option holder's positions will not increase in value and the time decay of the options will be a slow bleed. Conversely, the trader holding a short option position makes a bit of profit each day through time decay in a dead market. Add to this the lack of demand from directional option players in a dead market. Since the time decay of short dated options is higher than that of long dated options the selling is more pronounced in the short dated options this is reflected in the VIX and in the short dated futures hence contango (short dated futures at a discount to longer dated).

When the market heats up two things happen, those with short options scramble to reduce their risk of their short options moving into the money. If the expectation is for a short term boost in volatility the first move is to buy the cheapest options that are most sensitive to movements of the underlying (pushing the VIX, a calculated number based on near term options) and to push near term futures at a premium to the longer term futures = backwardization in the futures.

The CBOE has some data on the curve based on the differential between the cash VIX and the futures, the direction of that differential is usually the same as the shape futures curve as well as the SPX itself. Sharp downmoves in the lead to the VIX trading at a premium to the futures (and generally the futures curve going into backwardation). The chart of the fall 2008 market collapse period can be compared to the middle of 2009 and the market recovery. And since extremes of volatility coincide with sharp market declines it is not surprising to see the pattern in this chart from fall of 2008 of VIX cash VIX futures.

The CBOE website also has data for the relationship between the cash VIX the futures and the futures curve. Here is a great table. The higher the VIX the deeper the backwardation and vice versa. Not surprisingly, traders play this spread buying the near date and selling the further date in anticipation of high volatility and reversing the position when the outlook changes.

Average Realized VIX Spreads 1990-2003

Spot VIXSpot to 1 Month 1 to 2 months 2 to 3 months
15 to 20 4.02 1.64 1.74
20 to 25 0.92 0.85 0.25
25 to 30 -0.96 -1.24 -0.48
30 to 35 -3.23 -2.88 -1.57
35 to 40 -4.63 -2.94 -2.77
40 to 45 -9.95 -4.11 -2.33

The pattern was borne out in the recent market. Here are 1 to 2 month spreads around the flash crash date (below). The next post will comment on how to use this information in hedging and trading.

29-Apr 1.99
7-May -6.05
14-May 0.71

Disclosure: The author has a long position in VXX.

Source: The VIX Term Structure and What It Says About Future Volatility