VIX – watch the term structure

 

November 9, 2018

At the tail end of a particularly dismal month for global markets on October 26th the VIX broke 26 on the upside, a level not seen since last February. Since the start of November market volatility has begun to subside as equities rebound, but going forward investors should continue to focus on not only the VIX but also its term structure to gauge fear.

Key concepts in understanding the term structure are contango and backwardation.

In futures markets the term contango means that futures prices are higher than spot prices, and futures contracts with a longer duration to expiry command a price premium over short duration contracts. Plotted out, futures markets in contango show an upward sloping curve. Contango is considered to be the normal (non-volatile) situation in futures markets.

Futures markets in backwardation will show a downward sloping curve, as shorter duration contracts trade at a premium to longer duration contracts. Backwardation is abnormal, typically occurring when market participants are fearful.

Contango for medium term VIX futures is typically calculated by subtracting the 4th month futures’ price from the 7th month futures’ price, then dividing by the 4th month futures’ price. If this number is positive the futures term structure is in contango, if it is negative the market is in backwardation.

So where are we now?

The VIX term structure has been indicating a newfound calm this month having closed in contango for the past two days (+0.84% on Nov. 8th and +0.56% on Nov. 7th), and most investors are hoping it stays that way. However, this is on the back of a fearful October when backwardation prevailed for most of the month. The VIX term structure was also in backwardation during February this year, when the markets plunged and inverse VIX ETFs blew up. Other periods of backwardation include the China currency devaluation in 2015, the European sovereign debt crises and US credit downgrade in 2011, as well as the great recession in 2008.

Essentially, there is little to worry about when the VIX term structure is in contango, which historically is around 75% of the time. Today the VIX is around its long term average of 17, so investors seem neither complacent nor fearful. But investors should be mindful of when the term structure inverts, as this could be an indicator of headwinds for global markets.

 

 

Disclaimer: Please note that while Valbury Capital has made every attempt to ensure the accuracy and reliability of the information provided in this document it can give no warranty of any kind. The information provided is intended to be of a factual nature only and is not intended to amount to investment advice or to contain any form of investment recommendation. No person should rely on or use the information provided to form any investment decision