Updated: Apr 8, 2019
Regardless of how far along in your journey you are to understanding volatility markets, whether that's several years or just a few months, there's one thing that we all come back to and reference every single day. The VIX futures term structure.
VIX futures today Sept. 18, 2018 (from Vixcentral.com)
There are actually two very important data points that we take from this chart, but I think it's best if I split them up and unpack each on its own into two separate blog posts.
Part 1: Front two futures (M1 & M2)
I talk about it a lot so our VTS community is fully aware that those front two months of the VIX futures (M1 & M2) are quite important. The volatility ETP SVXY, as well as others like VXX, UVXY, TVIX, and the old XIV before it was terminated, don't derive their price based on regular supply and demand like other market assets do.
Instead, these volatility ETPs derive their price based on a daily rolling (buying and selling) of the front two months of VIX futures and the value of those futures at the time.
In the above chart, you can see M2 at 14.70 is substantially above M1 which is at 13.02. This is called contango, otherwise just called an upward sloping term structure. The percentage difference between M1 and M2 or this "contango value" is often quoted as a determining factor as to whether traders should hold long or short volatility positions. The commonly quoted advice is such:
M2 > M1 = Contango = Short volatility M2 < M1 = Backwardation = Long volatility
And of course the larger the contango value, the stronger the signal is said to be. So in that chart above, a contango value of 12.90% is quite high so that must be a strong signal to short volatility right?
Well, there's a big problem with this:
That doesn't take into account the number of days left on those futures contracts. Today September 18th is the last day of this monthly expiration cycle. Tomorrow everything will roll over to the new monthly expiration cycle.
M1 will be off the board M2 will become M1 M3 will become M2 etc. The whole board shifts down and starts over again
So it doesn't make much sense to use M2 and M1 as if it's a static snapshot in time does it? The better way to view this is as an ever-changing dynamic VIX futures term structure that moves forward in time to the next expiration cycle.
When you look at the VIX board tomorrow, the percentage level of contango (M2 > M1) is going to be much smaller. It won't be 12.9% as it's showing now. If nothing major changes over the next day, it could actually be closer to 3-4% by tomorrow.
Does that mean contango and the volatility risk premium (VRP) is dramatically less tomorrow than it is right now? That somehow something changed overnight? No of course not, that's just the static values that give people that impression. When viewed correctly, which is to say when viewed dynamically we can see that contango isn't really very high right now despite that deceiving 12.90% number.
If you really want an accurate picture of the volatility market, the VIX futures term structure needs to be viewed dynamically, taking into account all the values as well as the number of days to expiration.
There are several ways to do this and every trader is going to use it differently and put their own spin on it, but does this mean you will:
- Average M2, M1, and M3? - Use a rolling average of M2 and M1 contango? - Use M2 and M1 values, but a few days before start using M3? - Only use M2? - Use M3 to M2 contango? - Devise a formula that combines M2 and M1 with expiration days?
I could keep going and there is no specific right answer but the takeaway here is, don't forget the vital importance of days to expiration in your volatility analysis.
You don't want to be trading based on a limited understanding of the VIX futures term structure to the point where you changed positions from today to tomorrow based on a static contango value that is fairly meaningless on its own. We only want to change positions when something really has fundamentally changed, beyond just the passage of 1 day.
Stay tuned for part 2: VIX futures vs spot VIX index value