Contango or Backwardation? My recent “Futures in Volatility” article for the CFE’s “VIX Futures in Focus”

VIX Futures in Focus

One of the most exciting aspects of participating in the volatility conversation is, observing that as volatility markets continue to develop and a trading history is recorded, our understanding of the pricing of risk continues to evolve.

The CBOE Volatility Index (VIX) futures’ forward curve is now uniquely “V” shaped (not to be confused with the volatility moneyness smile). A more detailed look at the curve and its history is likely warranted in an attempt to better understand any significance to its current profile.

Sources: CBOE, Differential Research, LLC

The VIX futures’ forward curve is a graph that plots the prices of VIX futures with consecutive expirations displayed as a time-series. The forward curve represents the implied (expected) volatility. When viewed serially in this manner, market expectations for future volatility over time can be observed.

With data available from March 26, 2004, the forward curve has typically had a “contango” shape with prices rising prior to expiration. And while the current forward curve does not conform, a graph of the average price of each serial future echoes this contango shape.

Sources: CBOE, Differential Research, LLC

However, the average is not typically representative of the range. Graphing the historic highs and lows for the VIX serial futures illustrates the relative volatility of each serial future and defines the boundary of the forward curve’s historic range.

Sources: CBOE, Differential Research, LLC

Shorter term futures are typically more volatile than longer dated futures in times of high volatility. As a result, the forward curve often slopes downward with futures prices declining over time, or backwardation.

With futures prices in particular covering such a broad range, it is necessary to look at the first serial future, and look at the relative relationship providing further insight. For our analysis we use constantly compounded or lognormal returns. In addition to providing the basis to later evaluate the volatility of these relationships, this method yields a return that is meaningful from either future’s reference. For example, in our analysis the average constantly compounded discount between the first and second serial future is -4.61%, while the reciprocal 4.61% represents the average premium of the second over the first.

Sources: CBOE, Differential Research, LLC

Once again while the shortest term futures had the greatest discount on average, its greater volatility yields a wide range extending from a discount to the second month of 27.24% to a 40% premium.

Looking at the forest instead of the trees, we can look at the entire history of the relationship between VIX serial futures from inception in 2004 to September 21, 2011. In the graph below, each horizontal line represents a single day’s forward curve with green indicating a contango relationship between consecutive serial futures and red indicating a relationship in backwardation.

Once again we can see that the curve is more often contango and more significant (deeper green) as the time to expiration gets closer. Likewise periods of backwardation seem more common and more dramatic closer to expiration.

This perspective highlights the relative frequency of contango (green) to backwardation (red) and also suggests that the degree of contango and perhaps backwardation is greatest closer to expiration.

Presented in this manner each future will move from the lower right to the upper left. In our graph this shift is visible as the least expensive December future has moved from sixth to fourth serial position.

It appears that the movement of the shortest dated futures defines the shape of the forward curve, and while it is frequently believed that the relationship between the first and second serial future define the tenor of the entire curve, the data does not support that conclusion.

The current persistent backwardation in the front months, while not uncommon, is now the second or third largest in duration depending on whether 2008/2009 is considered one continuous period. The current period more closely resembles the July-August 2007 period when the front month future rose from the high teens to over 30.

Despite this added perspective the future for the forward curve as well as the price for volatility is unclear. The current shape represents a forward curve in transition, one that has moved from calm contango to one expressing elevated anxiety. The shape of the forward curve will likely be driven by the movement in the front month future. Change in volatility expectations are likely to return to contango as December moves into the first serial position.

A little about the data:

VIX futures history from 3/26/2004 is available on the CBOE website. Serial designation is based upon its relation to the underlying SPX options and not to its position relative to other VIX futures. For example, there may be a second but not a first serial future. If a serial future is missing but it is both preceded and followed by a serial future we have interpolated a serial future to fill in the time series while maintaining the existing relationships slope.

data sources: CFE, Trade-Alert LLC, Yahoo Finance and Differential Research LLC

The risk of loss in trading commodity futures and options is substantial. Before trading, you should carefully consider your financial position to determine if futures trading is appropriate. When trading futures and/or options, it is possible to lose more than the full value of your account. All funds committed should be risk capital. Past performance is not necessarily indicative of future results.