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Volatility Update: Backwardation for Market’s Fear Gauge

December 17, 2015
VIX fear gauge in backwardation

Volatility measures surged last week as the energy stock sector fell under the weight of tumbling crude oil prices and red flags waved in the high-yield bond market. These factors weighed on the broader stock market, handing Wall Street a series of losses ahead of this week’s highly anticipated Federal Reserve interest rate decision.

Although there were no obvious signs of stock-selling panic, it’s clear that anxiety levels have been building and some investors turned twitchy. The sudden market shift introduced a new relationship between near-term and longer-term volatility—a reversal from the norm (known as contango) to backwardation. We’ll get into that below.

By one measure, risk perceptions rose to multi-month highs. The CBOE Volatility Index (VIX) recaptured the psychologically significant “20” level, rising as high as 25 at one point on Friday. It was the highest level for the market’s so-called “fear gauge” since early October (see figure 1). While the VIX spiked, the S&P 500 (SPX) suffered a one-week, 3.8% drop—its steepest loss since August.

CBOE VIX spikes to 25


This one-year view of the CBOE Volatility Index (VIX) shows the “fear gauge” shooting to 25 intraday last Friday. Data source: CBOE. Chart source: TD Ameritrade’s thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

The energy sector led the retreat thanks to ongoing weakness in crude oil, but financials and other interest-rate-sensitive stock groups also ticked lower amid lingering Fed uncertainty. A degree of uncertainty went away on Wednesday, when the Fed delivered the first U.S. interest rate increase since 2006.

Follow That Curve

An interesting trend developed along the VIX “curve” as well. Recall that the volatility index is designed to track the implied volatility priced into short-term options on the SPX. Yet the SPX has options with expirations going out as far as December 2017, and each expiration month can have different levels of implied volatility.

In “normal” markets, longer-term SPX options have higher levels of implied volatility compared to short-term options for a very basic reason: the future usually packs more unknowns than the near-present.

The term “contango” describes the typical situation in which VIX futures are higher in more distant months compared to the front months. Last week, as VIX moved beyond 24, the curve shifted into serious “backwardation”—that is, the very short-term implied volatilities were higher than another expiration month (see figure 2).  

VIX plotline in backwardation


The near-term spike in VIX levels changes the shape of the plotline, which normally rises. Data source: CBOE. For illustrative purposes only. Past performance does not guarantee future results.

Typically, periods of backwardation prove to be short-lived. When they happen, it can be a sign that risk perceptions have become a bit too elevated. Negativity is at an extreme. Indeed, before last week, the VIX curve had not shifted into backwardation for many months, including during the mid-November market decline. In short, the spike in very short-term implied volatilities seemed to suggest to some traders that anxiety and nervousness were reaching an extreme last week. Maybe the bears were growling a bit too loud.

Time will tell whether the recent spike in VIX, along with the backwardation in the term structure, will prove fleeting or if they are the beginning of something more significant on the volatility front. 

Tom White’s RED Option Strategy of the Week: Diagonal Spread

Editor's Note: As of October 3, 2016, RED Option is now TradeWise.

Near-term options volatility spikes are especially notable as some traders reach to buy options for a degree of short-term protection. The options market collectively embraces this surge in volume and volatility, and the potential opportunities it packs. The diagonal spread is one such strategy that may draw increased interest in these market conditions. The diagonal spread is a directional, defined-risk spread that combines the time and volatility outlook of a calendar spread with the directional assumption of a vertical spread.

To create a diagonal spread, we buy a long-term option and sell a short-term option at a different strike price. Like calendar spreads, the hope with the diagonal is an expansion in volatility, thus increasing the value of our long option. We are also hoping that the price of the underlying trades near the strike of our short option, just like calendar spreads. The main difference between diagonal and calendar spreads is that the short and long options have different strike prices. The ideal situation for the diagonal spread buyer is for the underlying stock price to remain near the strike price of the option sold, heading into that option’s expiration. Time decay (theta) works in our favor and if volatility is elevated upon initiation, the credit received on the short portion of the trade in increased.

The ability to roll or adjust our short option to the long option cycle can also be a bonus. The credit received to roll the short option will reduce some risk and potentially increase profitability on the trade (excluding transaction costs). When this action is taken, the diagonal becomes a short vertical in the long-term cycle.

Occasionally in a high-volatility environment, you can "buy" a diagonal spread for a credit. That’s because the increased option premium in the short near-term cycle will completely offset the price paid for the longer-term cycle. Keep in mind that this is a scenario that may rarely show up outside of earnings or another volatility-inducing event. 

Rolling options strategies, spreads, and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. These are advanced option strategies and often involve greater risk, and more complex risk, than basic options trades.

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