Updated: Sep 14, 2019
In a previous article M1:VIX roll yield, I discussed how the true mechanism for how volatility ETPs derive their price isn't actually the absolute level of contango or backwardation in the VIX futures market as is so commonly stated. The true mechanism has to do with the value of the VIX futures and how they converge to the spot VIX at expiration.
So just to review because it's a very important point, here is the VIX futures term structure from that previous article labelled with the VIX futures and the spot VIX index.
VIX futures term structure on Apr 26, 2019:
The way this works is, every day the VIX futures move down the curve to the left towards expiration. On the third Wednesday of every month the front month M1 VIX future expires. When that happens, M1 disappears. The old M2 becomes the new M1. The old M3 becomes the new M2, M4 becomes M3, etc. All the futures move down the curve.
* I made a video you can check out discussing this VIX futures monthly expiration cycle
On the final day right before expiration, M1 converges to the spot VIX index price and they are one and the same. For only that moment right before expiration, M1=VIX. This is why we call it convergence to the spot VIX. Because everyday that goes by, those VIX futures are moving down the curve to the left and converging towards the spot VIX.
The shape of the VIX futures term structure:
- If the front month VIX futures are in contango (M2 > M1) and above the VIX index like they were in our example from Apr 26, 2019, because of the way they converge to the spot VIX at expiration that may be a tailwind for short volatility.
Potentially beneficial for the short volatility trade:
- If the front month VIX futures are in backwardation (M2 < M1) and below the VIX index like they were for example on Dec 24, 2019 below, then because of the way they converge to the spot VIX at expiration that may be a headwind for short volatility.
Potentially negative for the short volatility trade:
Why do we need to adjust M1:VIX roll yield?
The problem with the previous M1:VIX roll yield metric is, the volatility ETPs such as VXX, SVXY, UVXY, VIXY, TVIX derive their price based on a composition of first and second month VIX futures, M1 & M2.
It's actually a constant 1-month maturity VIX futures contract they are using in their methodology, which takes into account the days to expiration to determine the weighting.
So if we are just using the M1 contract by itself, it's not going to be an accurate measure of the true roll yield when we are near expiration. A few days before and a few days after, that M1 value can be quite skewed from the true level. This all has to do with how the volatility ETPs actually weight that constant maturity contract.
- At the beginning of the VIX futures expiration cycle, the volatility ETPs constant 1-month maturity contract is comprised of 100% of the new M1 value and 0% of the new M2 value.
- As the days roll forward, it's using slightly less of the front month M1 and slightly more of the back month M2.
- In the middle of the cycle it's using an equal weighting of M1 and M2.
- Right before expiration, they are using 100% of the back month M2 and 0% of M1.
- Then the futures expire, we start a new cycle, and the volatility ETPs constant 1-month maturity contract is again using 100% of the new M1 value and 0% of M2.
- Rinse repeat, every month this cycle continues.
So in order to have the best volatility metric with the highest predictive power, it has to be accurately taking into account the correct composition of VIX futures. Let me show you the easiest way to calculate this metric, which I call VX30:VIX roll yield
- M1 & M2 VIX futures values
- Trading days to VIX futures expiration
- Future roll / day (100% divided by # of trading days in the current cycle)
VX30 = (M1 * (days * roll)) + (M2 * (100% - (days * roll)))
VX30:VIX roll yield = (VX30 - VIX) / VIX
This VX30:VIX roll yield metric shows how much above or below the VIX index the current 1-month constant maturity VIX future is. Remember above or below the VIX, and how much potential decay there is as the VIX futures converge to the spot VIX at expiration is an important input variable for determining the highest probability volatility ETP trade.
The VIX futures weighting mechanism:
Using my spreadsheet below, I can show you the VX30 constant maturity future weighting and how it changes throughout the cycle.
RED: This is the first day of a new cycle, so the 1-month constant maturity contract is using 100% of M1, and 0% of M2. Notice how M1 is the same value as VX30?
GREEN: In the middle of the cycle, the 1-month constant maturity contract is using 50% of M1 and 50% of M2. Notice how VX30 is now the average of M1 and M2?
BLUE: On the first day of the following cycle, the VX30 is once again using 100% of M1 and 0% of M2, which means on the first day of the new cycle, VX30 = M1.
If we're using volatility metrics to guide our investing decisions, it's important to have the most accurate metrics. Most people talk about contango and backwardation and their analysis doesn't go much beyond that. A few of the more advanced volatility traders will know that the M1:VIX roll yield is an important additional metric to add in because the convergence to the spot VIX at expiration is the more meaningful mechanism.
However, the VTS community takes it even further than that, and calculates the true roll yield metric which is VX30:VIX. This metric takes into account the days to expiration and is a constant maturity weighting of the real VIX futures contract.
It's included in the VTS Volatility Dashboard as metric #6 of 20 and given every morning in my daily blogs to subscribers. I give both the absolute value, and a percentile ranking which is where that value ranks in relation to all its previous values since inception.
VTS Volatility Dashboard on May 28, 2019:
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