Introduction to VIX Term Structure
VIX Term Structure is an important concept for option traders, but it’s an advanced topic for new traders to grasp, so in this article, I’ll attempt to break it down into the key points. By the end of the article, you will understand:
- What VIX Term Structure is
- Key terms such as Contango and Backwardation
- How to use VIX Term Structure in your trading
- Examples of how the Term Structure is impacted during volatility spikes
What is VIX Term Structure?
VIX Term Structure is the term used by CBOE for a set of expected S&P500 Index volatilities based on S&P500 options of different time to maturity.
The VIX Index refers to a Volatility Index created by the Chicago Board Options Exchance (CBOE) that represents the market’s expectations of price movements in the S&P 500 over the next 30 days.
VIX is one number whereas the VIX Term Structure refers to a set of several numbers measuring expected volatility for different option expiry periods.
A great source for looking at the current and past VIX Term Structure is www.vixcentral.com
I look at this site almost daily to see what the market’s expectation of future volatility looks like. Below you can see an example of the VIX Term Structure. I’ll explain more about this later in the article.
Contango and Backwardation
Before diving into the Term Structure we need to understand these two key terms.
Contango and backwardation are key terms that come from the futures market. Contango refers to a situation where the price of a commodity is higher in the future compared to the current spot price.
The main reason for this is what’s called the cost of carry. If you think about it; it makes perfect sense.
Let’s say I know that I need 100 barrels of oil in 3 months’ time. I could buy the barrels today for $50, but then I have to pay storage costs for 3 months until I need it (cost of carry).
In this example, I might be willing to pay $51 to take delivery in 3 months rather than today, so that I don’t need to pay for storage.
Contango is the most common scenario for futures.
The opposite of Contango is Backwardation which occurs when the spot price is higher than the futures price.
In the commodities market, this situation might occur when there is a perceived shortage of a commodity and companies are willing to pay a premium to take delivery today in order to keep their production lines running.
While the terms Contango and Backwardation originated in the commodity futures market, they also apply to financial instruments.
Like commodities, there is a cost of carry with financial instruments. Rather than storage costs, the cost of carry on financial instruments is the interest rate paid to purchase and hold the instrument.
Most of the time financial futures, such as VIX Futures, are in Contango. However, when there is a market panic, they can flip into Backwardation pretty quickly.
Using VIX as an example, during a panic the spot price of VIX shoots higher, but the future price of VIX may not go up by as much.
This is because the market knows that panics usually die down within a few weeks and things return to normal.
You’ll see two great examples of this at the bottom of this article.
Why is the VIX Term Structure Important?
VIX Term Structure is important because it tells us a lot about the current state of the market.
When the Term Structure is in Contango, markets are in a calm state and are behaving normally.
When we shift to Backwardation, markets are in panic mode.
Sometimes panics can reverse quickly such as during Brexit, but other times the market can remain in Backwardation for an extended period such as during the financial crisis of 2008.
Yes, taking a contrarian view can be profitable when markets panic, but we also need to be aware that some of the worst market declines in history have come AFTER the VIX Futures market moved into Backwardation.
Trading Strategy for When VIX is in Contango
In this article, I discuss a strategy for trading VXX. The key premise is to:
- Wait for the market to move from Backwardation to Contango (likely means the panic is over)
- Buy VXX puts far out in time, usually that means at least 4-5 months for me. This gives the trade plenty of time to work out.
- Takes profits systematically as the trade moves in your favor.
VIX Term Structure Examples
When traders talk about a “volatility spike”, it’s important to realize that not all months on the Curve are impacted equally.
Spot VIX may have had a big rise, but future months likely were not impacted as much.
As mentioned earlier in the article, I want to use a couple of examples to illustrate this point and talk about why it’s important when trading options.
2017 was a very quiet time in the markets and volatility was incredibly low for most of the year. The VIX got as low as 8.84 on July 26th!!
On August 9th, 2017 VIX closed at 11.11, and the next day spiked 44% to 16.04. In percentage terms, this was one of the biggest spikes in history.
The chart below shows the VIX Term Structure on August 9th (blue) and August 10th (black).
Notice that on August 10th we flipped from Contango to Backwardation.
Also notice that the spike was the most pronounced in the front months of the curve.
This is VERY important to understand as option traders.
Anyone who was short volatility in those front month (short-term) options, would have been hit pretty hard.
The move was much less pronounced going out 90 days and further.
This is a key reason why I tend to focus on longer term trades these days, they are much less impacted by volatility spikes and P&L moves much slower allowing me more time to react.
Here’s another example from February 2018, commonly referred to as the “volpocalype”.
On February 5th, VIX spike an almighty 115.6% from 17.31 to 37.32.
The previous biggest spike (excluding the 1987 crash because VIX didn’t exist then) was 64.20% in February 2007.
Just let that sink in for a minute.
The spike was nearly twice as big as the previous biggest spike. It literally wiped out traders by the thousands and even saw the collapse of a few volatility ETF’s.
Below, you can see what happened to the VIX Term Structure on that day.
Similar to August 2017, not all months on the curve were impacted and most of the damage was concentrated in the front 3-4 months.
This handy graphic from Volateq shows the 25 largest VIX spikes since 1990 and what happened in the next few days.
You should now have a solid grasp of what the VIX Term Structure is and why it’s important for option traders. You also understand the key concepts of Contango and Backwardation.
The state of the Term Structure can be incorporated into an options trading strategy to improve performance.
Finally, we looked at a couple of examples of past volatility spikes and how these impacted the various months on the Curve.
Feel free to reach out any time with questions.
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.