Inside Volatility Trading: Is VIX Backwardation Necessarily a Sign of a Future Down Market?
Since the beginning of 2022, the Cboe Volatility Index® (“VIX”) futures curve has shifted higher, indicating that expectations for volatility in the market remain elevated. In fact, the 200 Day Simple Moving Average has risen from 18.59 on January 3rd to its current level of 24.03, a 29% increase. But what has happened to the shape of the VIX futures curve and how might this be a precursor of market performance?
The VIX Index is a financial benchmark designed to be a market estimate of expected 30-day volatility of the S&P 500 Index® and is calculated from both call and put options. It represents the expected range of movement (not necessarily direction), over the next 30 days. There are numerous VIX futures maturity dates and the VIX futures term structure is the relationship between VIX futures prices and VIX futures maturity dates. When a futures curve is trading in it’s “normal” pattern, it is said to be in contango, meaning the shape of the curve is upward sloping from left to right. Applied to the VIX futures, the VIX futures curve is in contango when near term VIX futures are cheaper than longer term VIX futures.
Here is an example of the VIX futures curve on July 15th:
Term Structure Data and Implied Volatility of Options on the S&P 500®
A state of contango represents the expectation that the VIX index will increase from its current level moving forward. The VIX futures curve is in contango more than 80% of the time since 2010. One possible explanation for this is the mean reverting nature of volatility where volatility can spend longer periods of time at lower or stable levels with occasional but mostly short-term spikes. The VIX futures contango is typically the steepest when the spot VIX Index is extremely low.
The opposite situation occurs when near term futures are more expensive and the shape of the futures curve becomes downward sloping and is known as backwardation. This may happen when near-term market conditions have more uncertainty than the longer term and hedging becomes more expensive (from a volatility standpoint) in the short term. Backwardation is not as common in the VIX futures curve as contango and happens less than 20% of the time since 2010. Periods of backwardation also tend not to last as long as periods of contango.
Here is an example of the VIX futures curve on May 2nd
Term Structure Data and Implied Volatility of Options on the S&P 500®
But is backwardation really a sign that the market may be headed for a fall? Outside of some of the biggest and most memorable market selloffs the results don’t pan out. When the VIX futures curve does go into backwardation it could signal weakness and overall risk in the market but the market can recover quickly. Examples of when this has occurred include the financial crisis in 2008, the European debt crisis in 2011, and more recently the Q4 2018 selloff that saw markets down for three straight months and then the start of the global pandemic in 2020. Shorting the market during those times may have worked out well but again, those gains may be given back rather quickly as some of the very best periods of stock market performance are immediately following some of the biggest selloffs.
The below chart shows the number of times the VIX futures curve has been in backwardation since 2018 and the S&P 500 30-day return following the month of the backwardation:
Month Beginning Backwardation vs. S&P 500 30-Day Return
Source: VIXCentral.com and YCharts.com
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