Where did contango go? VIX futures expiration cycle example

May 20, 2020

I get a lot of people asking how to calculate VIX contango and why it sometimes makes big changes day to day. Since we saw a big change today I thought we could go through the numbers. I know some of you already know this stuff, but it never hurts to go through live examples every now and then :)

Where did contango go?

* I have a full video at the bottom of this article if you prefer video

For anyone looking to profit from trading the various volatility ETPs on the market like VXX, UVXY, TVIX, SVXY, it is absolutely imperative that they first understand VIX futures and expiration cycles. The reason for this is something we talk about a lot at VTS and that is:

Volatility ETPs are not stocks

They don't derive their price based on supply and demand of the ETP itself. For example, VXX does not change price based on how many people buy or sell the VXX. Instead, volatility ETPs derive their price ONLY based on the changing value of the VIX futures contracts that they hold as those VIX futures contracts converge to the spot VIX index at expiration. It is a dynamic process over time.

VXX, UVXY, TVIX, VIXY, and SVXY are all short term VIX futures products, meaning they ONLY hold combinations of the front two month VIX futures which we call M1 & M2. Now I should mention, they can also hold some volatility swaps in addition to directly holding futures, but even those swaps are just based on the M1 & M2 VIX futures. So even when a portion of their holdings are swaps, it's still accurate to say that ONLY the front two month VIX futures M1 & M2 as well as the spot VIX index matter, nothing else.

Do you know what M1:M2 contango means?

Contango is the situation where further out in time contract prices are trading above nearer term prices. Quite often you'll see the term applied to commodity markets, but it also applies to the volatility complex.

Since the VIX futures term structure shows prices of all the monthly contracts out many months in the future, contango in the VIX futures market just refers to the situation where further out contracts are trading at a premium compared to nearer month contracts. We can look at a real example from yesterday's closing VIX futures values.

VIX futures term structure for May 19th, 2020 (vixcentral.com)

I've marked the M1 & M2 VIX futures there in green. As you can see, at market close yesterday they were in what we call contango, meaning the longer term M2 VIX future was trading above the nearer term M1 VIX future.

M1 = 30.750

M2 = 32.075

M2 > M1 = Contango

M1:M2 = (32.075 - 30.75) / 30.75 = 4.31% Contango

4.31% M1:M2 is the 39th percentile of all values going back to 2004. This means that 39% of the time contango is lower than it was yesterday, and 61% of the time it's higher.

But what about today, one day later?

VIX futures term structure for May 20th, 2020:

Doing the same calculation today that we did yesterday:

M1 = 30.70
M2 = 30.67
M1 > M2 = Backwardation
M1:M2 = (30.67 - 30.70) / 30.70 = -0.10% backwardation

* Backwardation is the opposite of Contango

-0.10% M1:M2 is the 17th percentile of all values going back to 2004.

Going from the 39th percentile down to just the 17th percentile seems like a massive one day move. Did something fundamentally change overnight that will affect volatility ETPs?

No, it didn't. All that happened was the passage of 1 day. This fact is especially important to factor in now, because today is VIX settlement and the start of the next monthly VIX futures cycle. Starting today:

Yesterday's M1 VIX future is gone
Yesterday's M2 VIX future is now today's M1
Yesterday's M3 VIX future is now today's M2
etc, right down the board...

Yesterday's M8 VIX future is now today's M7

The truth is nothing happened overnight, it was just a regular uneventful evening, but the level of M1:M2 VIX futures made a dramatic shift lower because the calculation is now using two different VIX futures than it was yesterday. M1:M2 contango has gone from 4.31% Contango on Tuesday to slight backwardation of -0.10% on Wednesday.

Very importantly though, this has no effect on the movement of the volatility ETPs.

They don't derive their price based on the absolute level of contango. They derive their price based on the changing values of VIX futures as they converge to spot VIX through the expiration cycle.

If a person was using the absolute level of M1:M2 VIX futures to base trading decisions on, they may get a dramatically different trade signal today. But that wouldn't make any sense because that's not how vol ETPs work. They always take into account the days to expiration.

What's the solution?

Focus on the VTS Adjusted M1:M2 VIX futures metric from the specialty volatility dashboard instead. This metric takes into account the number of days to expiration and is a far more accurate representation of the true level of contango from day to day.

Using the far more accurate "Adjusted M1:M2 VIX futures" metric, you can see the volatility complex hasn't actually moved into serious contango yet, and there certainly wasn't any dramatic change from yesterday to today.

Adjusted M1:M2 VIX futures year to date in 2020: