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Volatility Watch: Contango in VIX Futures and What to Do about It

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April 1, 2010
volatility futures contango
Fredrik Broden

There are many volatility derivative products to trade, including options, futures, and index products. If you look at an index of the average value of VIX futures over time versus the VIX itself, you’ll notice a couple of interesting things. First is that they can fall or rise more than the VIX index does. And second, they seem less volatile than the VIX itself—when the VIX spikes higher, for example, the VIX futures index doesn’t usually rise as much.

Both have to do with the index being based on the VIX futures prices, not the VIX itself, and it uses the front two VIX futures to approximate the exposure of a future with 30 days to expiration. When VIX futures are in "contango'" the further expirations are higher than the nearer expirations. When the index has to sell the near-month future and buy the further month to keep the weighting near 30 days, it loses a bit of money. And futures are generally less volatile than the cash or spot product they’re based on. Both of these things make the VIX futures index somewhat less than ideal for tracking the VIX directly, or as a hedge against rising volatility.

Now if you want to see whether the VIX futures are still in contango, the way to estimate the VIX futures prices if you don’t have the quotes is to use the VIX options. Subtract the price of the put from the price of the call and add that to the strike price. You can pick any strike, but it’s usually easier to pick a strike where the call and put prices are close to each other. If you do this for each expiration month, you’ll see that these “synthetic” futures prices are different across months.

So, what’s the bottom line? If you think that the VIX is low and may jump higher, then you might want to consider an out-of-the-money short-naked put. The max profit is the premium received, and the max loss and the breakeven point are both the strike price minus the premium.

If the VIX does rally, the short put could be profitable. If the VIX drops, then the short put will lose money. As a hedge, you might consider a bearish bias position in a VIX futures index or product in cases where the VIX futures are in contango and thus adding a bit of downward pressure on the index. If that is the case and the VIX rallies, the VIX put should make money, but the index shouldn’t rise as much, and overall the position should be profitable. If the VIX drops, the index should drop as well, hedging the short VIX put position. Of course, any complex options trade can involve significant commissions, trading costs, and risk, and this is only something more experienced traders should consider.