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VIX term structure as a trading signal

The VIX futures curve reflects expectations of future implied volatility of S&P500 index options. The slope of the curve is indicative of expected volatility and uncertainty relative to volatility and uncertainty priced in the market at present. Loosely speaking, a steeply upward sloped VIX futures curve should be indicative of present market complacency, while an inverted downward sloped curve should be indicative of present market panic and capitulation. In both cases the slope of the curve would serve as a contrarian indicator for market directional positions. An empirical analysis for 2010-2017 suggests that an inverted VIX curves has had a significant positive relation with subsequent S&P500 returns. Normal VIX curves, however, did not have significant predictive power, possibly because a market can stay complacent longer than it can panic.

Fassas, Athanasios and Nikolas Hourvouliades (2018), “VIX Futures as a Market Timing Indicator”, Working Paper, June 3, 2018

The post ties in with SRSV’s summary lecture on information efficiency and macro trends, particularly the section on using financial data.
The below are quotes from the paper. Emphasis and cursive text have been added.

What is the VIX futures curve?

“CBOE Volatility Index (known as VIX) was introduced by the Chicago Board Options Exchange in 1993 and was the first publicly available volatility index [implied by S&P 500 index options]. In 2004, the CBOE Futures Exchange (CFE) introduced futures contracts with VIX as the underlying asset and VIX options were launched in 2006. “

“The simple cost-of-carry arbitrage relationship between future and spot prices cannot be obtained for VIX and its futures contracts, since VIX is not directly investable. At any current point in time, the VIX futures price represents the risk-neutral expectation of VIX at the contract’s expiration and as a result, can vary significantly from the actual VIX level. The difference between future and cash prices is often called roll yield and it is positive when the VIX futures term structure is in contango (when the spot price is lower than the future prices) and negative when it is in backwardation (when the spot price is higher than the future prices). Market participants call it a yield because this price differential results in a small amount being made or paid every day as the futures and the spot prices gradually converge.”

“Since the level of VIX is calculated based on S&P500 call and put option prices, it reflects any positive or negative event that influence stock prices. Therefore, a negative shock on the stock market will drive put options prices higher and call options prices lower. Conversely, a positive shock will result in lower S&P500 put prices and higher call prices. The net result on the level of VIX, i.e. if the volatility index will rise or fall, depends on the relative size of the opposing call and put prices move. If the increase in option prices outweighs the respective decrease, VIX will increase and vice versa [which is usually the case if implied volatility increases].”

Why should we watch the VIX futures curve?

“The term structure of VIX futures embeds more information regarding the equity market dynamics than spot VIX.”

“Theoretically, when spot VIX is very low compared to its long-term average level…VIX futures trade at a premium because market participants expect that VIX will rise in the future. Conversely, when VIX is very high, VIX futures trade at a discount, implying that spot VIX will eventually decline to its normal levels.”

“Market participants very often use extreme levels of the VIX as a contrarian market timing indicator for the equity market…High levels of VIX are usually considered as capitulation signal that indicates under-valuation of stock prices… The downward sloping VIX futures term structure suggests that short-term volatility is relatively high compared to its long-term level and that investors expect a decrease in volatility in the future. This may prove bullish for the stock market as there is an inverse relationship between VIX and S&P500 returns (usually when VIX declines, S&P500 advances)…Conversely, abnormal low [present] VIX levels [relative to expectations for the future] indicate potentially excessive complacency and thus, may signal a market correction…[Generally] VIX futures premium discount compared to cash VIX can be related to investors’ [present] risk aversion [relative to expectations for the future], it may be informative regarding future stock returns.”

What are the empirical findings?

“We examine the dynamic dependencies between future equity returns and the term structure of VIX futures.”

“The data set of the current analysis consists of the daily closing prices of spot VIX and the seven nearest VIX futures for the period from January 04, 2010 to December 29, 2017…The present estimation of the VIX futures term structure…is conducted on each trading day by fitting a linear model of the available futures prices and spot VIX level as a function of time to maturity based on least squares criterion.”

“The mean VIX term structure estimate of 2.32 indicates that the level of VIX futures price increases on average, by 2.32 volatility percentage points per one-year horizon, or about 0.193 percentage points per month…Therefore, on average, during the period under examination the VIX futures term structure is upward sloping, i.e. short-term VIX futures trade at lower price than long-term contracts.”

“The range of observations is relatively large, suggesting that the VIX futures term structure is considerably time varying. In fact, as shown in [the graph below]. VIX futures term structure may change considerably and turn from upward sloping to downward sloping and vice versa in a limited period of time.”

“The coefficient of negative slope has a negative sign in all cases and it is statistically significant…This means that when the estimated VIX term structure takes negative values (i.e. the VIX futures are in backwardation) the subsequent future return of S&P500 is positive….On the contrary, the coefficient of the positive term structure is not statistically significant…suggesting that when the VIX futures term structure is in contango (as it normally is) there is no meaningful market timing signal for S&P500 returns.”

“The empirical findings show that VIX futures term structure can be used as a stock market predictive tool and particularly that the negative slope of the structure can be considered as a contrarian market timing indicator. This finding seems consistent with investors’ view that a downward sloping VIX term structure is as an indication of an oversold market.”

What can be done if the VIX curve is in contango?

“The VIX term structure…can also be used for constructing trading strategies that attempt to earn the term structure risk premium, when it is in contango. An investor that simultaneously buys VIX and S&P 500 Index puts for the same expiration month can capture this volatility premium. At expiration, the prices of spot and future VIX should converge, therefore, either spot VIX will rise or VIX futures price will fall. In the first case, if spot VIX advances, the VIX puts will be worthless, but, most likely, the S&P500 puts will be profitable.”


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