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 3^rd 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 15^th:

Term Structure Data and Implied Volatility of Options on the S&P 500® 

Source: Cboe.com

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 2^nd

Term Structure Data and Implied Volatility of Options on the S&P 500® 

Source: Cboe.com

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

Industry News

• Bloomberg: Wall Street Set for New ETF Gold Rush as Single-Stock Era Begins
• FX Markets: Will last look disclosures come to FX derivatives?
• Markets Media: ETFs in Europe Have First Net Outflows After 26 months

Events

• July 27: Trading & Hedging with VIX Futures
• July 27: Options: Electronically & on Trading Floor
• August 9: Options Institute Spread Strategies

Volatility411

Get This Newsletter Sent to Your Inbox

Get the Inside Volatility Trading newsletter directly in your inbox by signing up here.

There are important risks associated with transacting in any of the Cboe Company products discussed here. Before engaging in any transactions in those products, it is important for market participants to carefully review the disclosures and disclaimers below.

^General

^{The information provided is for general education and information purposes only. No statement provided should be construed as a recommendation to buy or sell a security, future, financial instrument, investment fund, or other investment product (collectively, a “financial product”), or to provide investment advice.}

^{In particular, the inclusion of a security or other instrument within an index is not a recommendation to buy, sell, or hold that security or any other instrument, nor should it be considered investment advice.}

^Options

^{Options involve risk and are not suitable for all market participants. Prior to buying or selling an option, a person should review the Characteristics and Risks of Standardized Options (ODD) , which is required to be provided to all such persons. Copies of the ODD are available from your broker or from The Options Clearing Corporation, 125 S. Franklin Street, Suite 1200, Chicago, IL 60606.}

^{Trading FLEX options may not be suitable for all options-qualified market participants. FLEX options strategies only should be considered by those with extensive prior options trading experience.}

^{Uncovered option writing is suitable only for the knowledgeable market participant who understands the risks, has the financial capacity and willingness to incur potentially substantial losses, and has sufficient liquid assets to meet applicable margin requirements. In this regard, if the value of the underlying instrument moves against an uncovered writer's options position, the writer may incur large losses in that options position and the participant’s broker may require significant additional margin payments. If a market participant does not make those margin payments, the broker may liquidate positions in the market participant’s account with little or no prior notice in accordance with the market participant’s margin agreement.}

^Futures

^{Futures trading is not suitable for all market participants and involves the risk of loss, which can be substantial and can exceed the amount of money deposited for a futures position. You should, therefore, carefully consider whether futures trading is suitable for you in light of your circumstances and financial resources. You should put at risk only funds that you can afford to lose without affecting your lifestyle.}

^{For additional information regarding the risks associated with trading futures and security futures, see respectively the Risk Disclosure Statement set forth in Appendix A to CFTC Regulation 1.55(c) and the Risk Disclosure Statement for Security Futures Contracts.}

^{VIX® Index and VIX® Index Products}

^{The Cboe Volatility Index® (known as the VIX Index) is calculated and administered by Cboe Global Indices, LLC. The VIX Index is a financial benchmark designed to be a market estimate of expected volatility of the S&P 500® Index, and is calculated using the midpoint of quotes of certain S&P 500 Index options as further described in the methodology, rules and other information here .}

^{VIX futures and Mini VIX futures, traded on Cboe Futures Exchange, LLC, and VIX options, traded on Cboe Options Exchange, Inc. (collectively, “VIX® Index Products”), are based on the VIX Index. VIX Index Products are complicated financial products only suitable for sophisticated market participants.}

^{Transacting in VIX Index Products involves the risk of loss, which can be substantial and can exceed the amount of money deposited for a VIX Index Product position (except when buying options on VIX Index Products, in which case the potential loss is limited to the purchase price of the options).}

^{Market participants should put at risk only funds that they can afford to lose without affecting their lifestyles.}

^{Before transacting in VIX Index Products, market participants should fully inform themselves about the VIX Index and the characteristics and risks of VIX Index Products, including those described here. Market participants also should make sure they understand the product specifications for VIX Index Products ( VIX futures , Mini VIX futures and VIX options ) and the methodologies for calculating the underlying VIX Index and the settlement values for VIX Index Products. Answers to questions frequently asked about VIX Index products and how they are settled is available here .}

^{Not Buy and Hold Investment: VIX Index Products are not suitable to buy and hold because:}

• ^{On their settlement date, VIX Index Products convert into a right to receive or an obligation to pay cash.}
• ^{The VIX Index generally tends to revert to or near its long-term average, rather than increase or decrease over the long term.}

^{Volatility: The VIX Index is subject to greater percentage swings in a short period of time than is typical for stocks or stock indices, including the S&P 500 Index.}

^{Expected Relationships: Expected relationships with other financial indicators or financial products may not hold. In particular:}

• ^{Although the VIX Index generally tends to be negatively correlated with the S&P 500 Index – such that one tends to move upward when the other moves downward and vice versa – that relationship is not always maintained.}
• ^{The prices for the nearest expiration of a VIX Index Product generally tend to move in relationship with movements in the VIX Index. However, this relationship may be undercut, depending on, for example, the amount of time to expiration for the VIX Index Product and on supply and demand in the market for that product.}
• ^{Mini VIX futures contracts trade separately from regular-sized VIX futures, so the prices and quotations for Mini VIX futures and regular-sized VIX futures may differ because of, for example, possible differences in the liquidity of those markets.}

^{Final settlement Value: The method for calculating the final settlement value of a VIX Index Product is different from the method for calculating the VIX Index at times other than settlement, so there can be a divergence between the final settlement value of a VIX Index Product and the VIX Index value immediately before or after settlement. (See the SOQ Auction Information section here for additional information.)}

^{Exchange Traded Products ("ETPs")}

^{Cboe does not endorse or sell any ETP or other financial product, including those investment products that are or may be based on a Cboe index or methodology or on a non-Cboe index that is based on investment products trading on a Cboe Company exchange (e.g., VIX futures); and Cboe makes no representations regarding the advisability of investing in such products. An investor should consider the investment objectives, risks, charges, and expenses of these products carefully before investing. Investors also should carefully review the information provided in the prospectuses for these products.}

^{Investments in ETPs involve risk, including the possible loss of principal, and are not appropriate for all investors. Non-traditional ETPs, including leveraged and inverse ETPs, pose additional risks and can result in magnified gains or losses in an investment. Specific risks relating to investment in an ETP are outlined in the fund prospectus and may include concentration risk, correlation risk, counterparty risk, credit risk, market risk, interest rate risk, volatility risk, tracking error risk, among others. Investors should consult with their tax advisors to determine how the profit and loss on any particular investment strategy will be taxed.}

^{Cboe Strategy Benchmark Indices}

^{Cboe Strategy Benchmark Indices are calculated and administered by Cboe Global Indices, LLC as described in the methodologies, rules and other information available here using information believed to be reliable, including market data from exchanges owned and operated by other Cboe Companies.}

^{Strategy Benchmark Indices are designed to measure the performance of hypothetical portfolios comprised of one or more derivative instruments and other assets used as collateral. Past performance is not indicative of future results. Strategy Benchmark Indices are not financial products that can be invested in directly, but can be used as the basis for financial products or managing portfolios.}

^{The actual performance of financial products such as mutual funds or managed accounts can differ significantly from the performance of the underlying index due to execution timing, market disruptions, lack of liquidity, brokerage expenses, transaction costs, tax consequences and other considerations that may not be applicable to the subject index. Index and Benchmark Values Prior to Launch Date}

^{Index and benchmark values for the period prior to an index’s launch date are calculated by a theoretical approach involving back-testing historical data in accordance with the methodology in place on the launch date (unless otherwise stated). A limitation of back-testing is that it reflects the theoretical application of the index or benchmark methodology and selection of the index’s constituents in hindsight. Back-testing may not result in performance commensurate with prospective application of a methodology, especially during periods of high economic stress in which adjustments might be made. No back-tested approach can completely account for the impact of decisions that might have been made if calculations were made at the same time as the underlying market conditions occurred. There are numerous factors related to markets that cannot be, and have not been, accounted for in the preparation of back-tested index and benchmark information.}

^Taxes

^{No Cboe Company is an investment adviser or tax advisor, and no representation is made regarding the advisability or tax consequences of investing in, holding or selling any financial product. A decision to invest in, hold or sell any financial product should not be made in reliance on any of the statements or information provided. Market participants are advised to make an investment in, hold or sell any financial product only after carefully considering the associated risks and tax consequences, including information detailed in any offering memorandum or similar document prepared by or on behalf of the issuer of the financial product, with the advice of a qualified professional investment adviser and tax advisor.}

^{Under section 1256 of the Tax Code, profit and loss on transactions in certain exchange-traded options and futures are entitled to be taxed at a rate equal to 60% long-term and 40% short-term capital gain or loss, provided that the market participants involved and the strategy employed satisfy the criteria of the Tax Code. Market participants should consult with their tax advisors to determine how the profit and loss on any particular option or futures strategy will be taxed. Tax laws and regulations change from time to time and may be subject to varying interpretations.}

^General

^{Past performance of an index or financial product is not indicative of future results.}

^{Brokerage firms may require customers to post higher margins than any minimum margins specified.}

^{No data, values or other content contained in this document (including without limitation, index values or information, ratings, credit-related analyses and data, research, valuations, strategies, methodologies and models) or any part thereof may be modified, reverse-engineered, reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of Cboe.}

^{Cboe does not guarantee the accuracy, completeness, or timeliness of the information provided. THE CONTENT IS PROVIDED “AS IS” WITHOUT WARRANTY OF ANY KIND, EITHER EXPRESS OR IMPLIED, INCLUDING, WITHOUT LIMITATION, ANY WARRANTY WITH RESPECT MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE.}

^{Hypothetical scenarios are provided for illustrative purposes only. The actual performance of financial products can differ significantly from the performance of a hypothetical scenario due to execution timing, market disruptions, lack of liquidity, brokerage expenses, transaction costs, tax consequences and other considerations that may not be applicable to the hypothetical scenario.}

^{Supporting documentation for statements, comparisons, statistics or other technical data provided is available by contacting Cboe at www.cboe.com/Contact .}

^{The views of any third-party speakers or third-party materials are their own and do not necessarily represent the views of any Cboe Company. That content should not be construed as an endorsement or an indication by Cboe of the value of any non-Cboe financial product or service described.}

^{The inclusion of research not conducted or explicitly endorsed by Cboe should not be construed as an endorsement or indication of the value of that research.}

^{Trademarks and Intellectual Property}

^{Cboe®, Cboe Global Markets®, Bats®, BIDS Trading®, BYX®, BZX®, Cboe Options Institute®, Cboe Vest®, Cboe Volatility Index®, CFE®, EDGA®, EDGX®, Hybrid®, LiveVol®, Silexx® and VIX® are registered trademarks, and Cboe Futures ExchangeSM, C2SM, f(t)optionsSM, HanweckSM, and Trade AlertSM are service marks of Cboe Global Markets, Inc. and its subsidiaries. Standard & Poor's®, S&P®, S&P 100®, S&P 500® and SPX® are registered trademarks of Standard & Poor's Financial Services LLC and have been licensed for use by Cboe Exchange, Inc. Dow Jones®, Dow Jones Industrial Average®, DJIA® and Dow Jones Global Indexes® are registered trademarks or service marks of Dow Jones Trademark Holdings, LLC, used under license. Russell, Russell 1000®, Russell 2000®, Russell 3000® and Russell MidCap® names are registered trademarks of Frank Russell Company, used under license. FTSE® and the FTSE indices are trademarks and service marks of FTSE International Limited, used under license. MSCI and the MSCI index names are service marks of MSCI Inc. (“MSCI”) or its affiliates and have been licensed for use by Cboe. All other trademarks and service marks are the property of their respective owners.}

^Copyright

^{© 2022 Cboe Exchange, Inc. All Rights Reserved.}