So You Want To Trade Volatility: Understanding Backwardation

by: Josh Krause

After going over the basics of volatility in the first article in this series and crushing hopes and dreams with an anaylsis of Contango, it is time to talk about happier things and delve into VIX Backwardation.

Backwardation in the futures market is when the price of the future month contract is less than the current price. This is the norm in futures for the S&P-500 (SPY) where next month futures are lower than whatever the current price is due to lowered expectations for the future.

Textbook Backwardation would look like this:

Spot VIX: 22.00

Front Month Futures: 20.00

Next Month Futures: 18.00

But VIX enters Backwardation only when things are extremely volatile and typically doesn't start until VIX hits 30+. A more realistic model for VIX Backwardation would be something more like this:

Spot VIX: 35.00

Front Month Futures: 30.00

Next Month Futures: 25.00

This structure indicates that the market is in crisis currently (spot VIX at 35 is forecasting a 10.1% move in the S&P 500), but the expectation is that it will abate in the future. The higher spot VIX goes, the steeper the Backwardation in VIX futures. For anyone holding a long position in volatility products (VXX, UVXY, TVIX, or short XIV, SVXY) this is your fantasy land, where dreams come true for those daring enough to hold through the crisis.

Backwardation In Action

VIX futures entered Backwardation last summer with VIX spiking above 40 in August. Even with the spot Value in VIX hitting a peak on August 8th, VXX did not hit the highs until October 4th due to Backwardation in the futures. Just as Contango eats away at a long position, Backwardation will continually benefit a long volatility position for as long as the futures maintain the structure.

VIX Summer 2011 PerformanceClick to enlarge

VXX Summer 2011 PerformanceClick to enlarge

XIV Summer 2011 PerformanceClick to enlarge

You can see the lag between VIX peaks and Futures related products in the charts above from summer 2011. Even though VIX peaked on August 8th, the futures were in Backwardation all the way until an initial bottom on October 4th. We were then on our way back to Contango until the Euro crisis flared up again and sent the futures back into backwardation and made a new low in XIV in November.

When the fever does not break and we head to 30+ in spot VIX, the gains in volatility products can be multiplied many times over through the course of the crisis. The summer of 2011 provides us a working example of what Backwardation in VIX futures can do for those holding long volatility products.

Let's Get Real

By now readers of this series should have a good grasp of the basics of Contango and Backwardation. While anyone playing long volatility dreams about VIX futures entering Backwardation, you have to recognize what is required to reach those levels.

Last summer the markets were broken by the Debt Ceiling debacle and the US debt downgrade. Then we fell further down the rabbit hole with fears of Global Recession and a Euro breakup. While it wasn't exactly the same EOTWAWKI scenarios that were flying around in 2008-2009, we were definitely in some dire straits. That is the level of crisis that the markets need to reach for backwardation to kick in. One can maintain crisis mode for only so long, so it should come as no surprise that VIX futures are in Backwardation less than 30% of the time.

Even with that being the case, we can still model out how backwardation can benefit volatility players. By taking the same 0.5% daily roll cost from the Contango article and inverting it, we will be modeling what a daily backwardation gain would look like for those holding VXX and UVXY.

Backwardation Simulation

Through the miracle of compounding we get additional gains in our volatility products as long as VIX remains in Backwardation. The longer this goes on, the higher VXX and related products can go. The leveraged volatility products (UVXY, TVIX) magnify this and can really get out of hand. In the panic last summer we saw TVIX rise 500% (15 to 110) on a 200% move in spot VIX (15 to 45). Those additional gains were the futures entering Backwardation and the gains compounding over time.

While Backwardation is obviously the state that long volatility holders want to be in, the markets enter this structure rarely and only during times of true crisis. Whenever spot VIX heads to 20+, there is talk of VIX entering Backwardation. Even during the smaller crisis in May, VIX was technically in Backwardation for a day or two, but the panic subsided and the fever broke.

I want everyone thinking about VIX entering Backwardation to take a look at the charts from last year and think on them for a moment. While there was an obvious spike in August, there was still plenty of meat left on the bone for late comers to the volatility trade. Backwardation will allow those who wait to still profit substantially, so don't be too upset if you miss the initial spike and you believe that the panic will last for an extended period of time.

In the next installment of this series I will look into holding periods for the various short term volatility products on the market today.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.