The Relationship of Prices of VIX® Futures contracts to the VIX® Index
Prices of VIX futures contracts have unique characteristics, because they may be either higher or lower than the underlying VIX index. This occurs because market expectations of volatility in the future may vary from month to month.
Assume, for example that today is August 10 and the VIX index is 20. If market expectations are for 30-day implied volatility to be higher than 20 in October and lower than 20 in December, then October VIX futures will be trading at a level above 20 and December VIX futures will be trading below 20.
This pricing relationship of the VIX futures relative to the underlying "spot" index is unique. Most futures contracts are based on a "cost of carry" relationship to the underlying instrument, by which the futures contract replicates the performance of the underlying instrument. Replication of an underlying instrument may be as easy as taking a position in a U.S. treasury security or as complex as buying a portfolio of stocks that mirror the performance of the SPX.
If a trader has the ability to replicate the performance of the underlying instrument, then he may also take advantage of a "mispricing" between a futures contract and the underlying market. Arbitrage trading firms attempt to take advantage of such "out-of-line pricing" when it occurs. This sort of market activity causes futures contracts to trade within a narrow range "close" to the price of the underlying instrument.
In contrast to the arbitrage trading discussed above, the ability to replicate the performance of the VIX index does not exist in the same manner as other financial products or indexes. The VIX index is calculated using the mid-point between the bid and offer of the SPX option contracts, and this mid-point pricing does not necessarily represent a market price where a VIX futures contract may be readily traded. The result is an inability of traders to quickly trade SPX option contracts to lock in a 30-day implied volatility versus the VIX index. With the inability to arbitrage between the VIX index and VIX futures, there is no arbitrage value relationship between the two instruments.
The chart below shows the price relationship between the VIX index and the August 2011 VIX futures contract over the last six weeks leading up to August VIX index expiration. The blue line shows the August contract's closing prices and the red line represents the VIX index. Note that, at different times, the futures contract trades at both a premium and a discount to the index during this time period.
VIX® Futures (blue) compared to the VIX® Index (red)