VIX Futures: A Primer
Updated: May 19, 2019
Today the market has shown some bearish teeth and vol has raised its head again. So, I thought a discussion on VIX Futures was pertinent.
VIX Futures are an excellent trading and hedging tool. The CBOE started the contract in 2007, and after adapting the pricing and issuance structure in 2009, volumes started to grow pretty dramatically. I’d like to talk a bit about how these futures are priced and then explain how they can be used by the average investor to get a more nuanced view on the market.
Ok, so what are VIX Futures? From the CFE (the CBOE’s futures exchange), “VIX futures reflect the market's estimate of the value of the VIX Index on various expiration dates in the future.” Ok, clear as mud. The VIX is a measure of constant 30-day forward implied volatility. The market generally uses the VIX Index as a measure of risk. The VIX itself is not predictive of market movements; it simply represents the price participants are willing to pay for 30-day forward insurance (options). VIX futures are essentially an at-the-money (ATM) options straddle that always stays at the money (unlike an options straddle which will drift with the underlying).
VIX Futures “settle” into the VIX. This means that on expiration day, the front VIX future contract price converges to the VIX price and the transaction settles into cash. These contracts expire each month and generally there are 9 months of listed contracts trading. So, you can think of each contract as a 30-day ATM forward contract on volatility, or as a segment of a vol curve.
Unlike options, which have Black-Scholes to price them, VIX futures have no closed-form pricing mechanism. In fact, they are rather difficult to price since they resemble both a variance swap and a forward contract. Because VIX futures represent the ATM volatility, they can be priced based on the SPU (S&P 500 futures) option implied vol surface. This has the very nice effect of making the contract especially effective for options market makers to hedge volatility. They can also be priced with a beta function to VIX, but that’s far less precise.
Once the contract achieved some liquidity by being useful to options market makers, it also became a good foundation to build VIX ETFs upon. These ETFs (which are really Exchange Traded NOTES, not FUNDS), are priced with strict formulas to VIX Futures. I mention this because of the infamous XIV ETF.
XIV’s pricing formula dictated that it move inversely to a weighted average of the front two VIX futures contracts. If that weighted average moved N% up, XIV moved -N% down. This contract was popular because of the VIX future term structure “roll-down.”
Normally the VIX complex is “backward-dated.” Picture below. This means that future VIX contracts are more expensive, priced higher, than contracts closer to expiry. Intuitively this makes sense; more stuff can happen in the future so more “optionality” exists. As these future contracts roll down, they naturally lose value. So, if you are short a weighted average of the front two contracts, each day you will receive the roll-down even IF the contracts don’t move. This is why long VIX ETNs constantly lose value. If you understand options pricing, this is Theta, the time value of options being wrung out of the contract.
Back to XIV. Because this contract perfectly captured the roll-down, and was short outright volatility, which was going down dramatically since 2009, buying this ETN was one of the favorite trades of all hedge fund types. How could it lose?!
Its doom was written right there for anyone to read in the prospectus. What happens if the weighted average of the front two contracts goes up 100%? XIV should go down 100%, to ZERO. In February 2018 the VIX Index was around 16 with VIX Futures around the same price. Just a few days earlier the VIX Index had traded as low as 8. Doubling a value from a low number isn’t that hard and that’s what happened on Feb 8, 2018, the VIX spiked over 100% to the mid-’30s. XIV was DOA.
Two important things should be gained from that anecdote: First, make sure you read the prospectus and understand your investments fully. If you don’t understand, don’t trade. Second, the term structure of VIX futures has information in it.
Keeping track of the VIX future term structure and the trend in that term structure is informative as to the direction of the stock market, and to some extent the vol market, in the short-term. It tells you where risk is currently priced and where the market prices risk in the future. Normal / Backwardated curves are generally bullish for the market, Contango curves bearish.
Hope that helps.