VIX Futures Term Structure Explained

Video Transcript:

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Welcome back volatility traders to the next lesson in this course. Now, quick reminder, this is going to be a multi-part series breaking down all the important aspects of the volatility complex to help you maximize your volatility trading profits. Now, of course, most of that is going to be short volatility profit, but don't forget that at certain strategic times, the long volatility trade can be extremely profitable as well when the market crashes.

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Smart traders take advantage of both sides of that coin, short and long. So if you want to learn how to trade volatility the right way, you can see all my live trades for each of our strategies and really dive into the course material. That's part of the VTS community.

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There's a free trial on the website. You can check it all out before committing. But today we have to break down arguably the most important aspect of the entire volatility trade that we all love so much.

We need to have a full understanding of how the VIX futures term structure actually works. Now you might be thinking to yourself, well, who cares about all of this? I don't even trade VIX futures. Well, fair enough.

But do you trade any of these? Every one of the volatility products on the market, they do hold VIX futures. So you might not trade the VIX futures, but the UVXY does. The S-VIX does.

If you want to maximize your trading edge, you have to understand how the expiration cycles work. So the example we're going to use for this is for December 29th, 2023. This is a really clean term structure, so it's going to be a good example today.

And remember, you can check this out anytime yourself at VIXcentral.com. Just bookmark that website and you can reference it daily. So what we're looking at here are all the VIX futures prices for each month, starting with that first one in January, which we will call M1 for month one. Now you might also hear people call it VX1, but M1 is how I always refer to it.

And then each dot further out is the next monthly VIX future price. So we've got M2 for February, M3 for March, and these go all the way out to September. Now it's important to remember that while the volatility ETPs themselves, they do track underlying indexes and a set methodology.

We'll get into that in the next lesson in the course, but those VIX futures are a freely traded market. These are just buyers and sellers making forward predictions of where they think volatility will be at future dates. And based on that activity, we can see the price that each VIX future is trading at.

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But the next layer to this system is that these are not static. Of course, time is always moving forward. So if I go into my spreadsheet here where I track all this stuff, and we go ahead and find that December 29th date, as we scroll over, we can see that right now there is 11 days left to expiration.

And this cycle had a total of 17 days, but we are at 11 currently. Now, if you're tracking this stuff yourself, you can see that different months have a different number of days. This one above had 24, the one above that had 20, but this current month had 17, and right now we have 11 left.

Now also importantly, we can see over here, the VIX index on that day was 1245. So now we'll mark the VIX index on here as well at a price of 1245. Now for the next 11 days, this front month VIX future M1, it will be ticking down to the left towards expiration a little bit each day for 11 more days.

And all of the other VIX futures will also be ticking down to the left with each passing day as well. All the VIX futures are constantly moving to the left with the passage of time. Now on expiration day, when the front month M1 future has zero days left to expiration, that price will be exactly the same value as the VIX index.

For that one day only, these two prices will be the same value. Now I cannot stress how important this point is. On expiration day, that front month M1 VIX future contract will be the same value as the VIX index.

And then because of course time is still moving forward, what happens next is that front month M1 VIX future expires. It is removed from the board completely. And then the following day, the future that was the M2 before expiration now becomes the new front month M1 VIX future after expiration.

The old M3 becomes the new M2, M4 becomes M3, all the way down the line and the new cycle begins. Now because it's a new cycle, these futures are free to move around. People are still making their bets, so this new M1 future will decouple from the VIX index again.

You can see if the term structure remains stable, it's not going to be the same price as the VIX anymore. There may be around 20 days in this cycle. On average, that's about what it is.

And each day, all the futures are ticking towards expiration again. So you can see what's happening here. You've got all the VIX futures priced out into the future.

And then with each passing day, they are all ticking down to the left as time goes by. On that expiration day, just for that moment, that front month M1 future will equal the VIX index. Then it expires, it drops off the board completely.

All of those futures move down to the next month and the cycle begins again. Rinse, repeat, month after month. This has been happening with VIX futures since they launched in March, 2004.

So again, if you catch yourself saying, well, I don't need to know all this stuff. I don't actually trade VIX futures. All of the other volatility products, they do trade VIX futures.

So you really do need to understand this if you want to be successful. So now you can either go to the next level of education and learn how those volatility ETFs actually function based on the VIX futures. Or you can check out this video where I explain how I personally use the volatility products to make over 30% a year with tactical rotation.

See you in the next video.