Going out on a limb here, but you’ve probably heard two things about the CBOE VIX lately. One, it’s a “fear index” that gauges market sentiment. And two, that it’s broken.
Broken? Certainly, the index must provide some insight into market sentiment, right? But rather than get out-foxed by guessing where the VIX will peak or trough, let’s jump right in and talk about “term structure” and backwardation—when the price of a future is lower than the current cash price (spot price) of an underlying asset. Using the S&P 500 as the benchmark, when the market falls, VIX typically rises. As you’re watching for signs of capitulation (sellers washing out), you want to be looking for peaks in the VIX at prior highs, or even higher. But will the peak be 18, 22, 30, or some greater value? When analyzing VIX futures, you may find the greater concern isn’t about the overall level of the VIX at all. But rather the term structure.
The Market’s Morse Code
VIX futures (/VX) are made up of various expirations based on where the market thinks the VIX will be at different points in the future. These expirations move up and down together, but generally not at the same rate. As the VIX reaches extreme highs, you’ll typically find that the longer expirations move up less, creating a situation where the price of the front month VIX contract may shoot higher than longer expirations.
This type of structure is referred to as “backwardation.” Figure 1 is an example of backwardation taken on February 3, 2014 using the “Product Depth” feature on the thinkorswim® platform (located in the sub-menu at the top of the Charts page). You’ll notice that the March contract was trading at 18.59 (the first point on the left), which is higher than both April and May which were trading at 18.44 and 18.51, respectively. This indicates that the /VX market is in backwardation and often times marks a near-term low in the market.
OK, so now we have a signal that the market may bottom. The next challenge is how to trade it. While there’s more than one way to skin a fox, the leverage-and-reward potential that futures provide can be attractive for some investors willing to assume the risks. For example, consider a simple trading system using the E-mini S&P 500 Index Futures (/ES) as follows:
1. /VX closing in a backwardation condition AND
2. /ES closes below previous day’s close by >1 x 14-day ATR
1. Trailing stop set 1.5 x 14-day ATR
2. Roll to next month with 10 days to expiration
On February 3, 2014 the fourteen-period Average True Range (ATR) was at 19.88. With the /VX closing in backwardation, and /ES having closed more than one times the ATR, or $44 lower than the previous day’s close at 1733, an entry was triggered. The trail stop would have been set $29.82 (1.5 x ATR of 19.88) below the entry price.
Upon entry, the active contract would be traded and should be rolled to the next month 10 days before expiration. The exit occurred on March 3 when /ES had a correction of more than $29.82 below the highest priced reached—which triggered the stop and the trade was automatically closed. Over the period from June 2013 through June 2014, this strategy would have produced about five trades that would have lasted on average a little over a month.
The VIX is an enigmatic market animal that many watch but few are really able to hear what it’s trying to tell them. The focus on level is part of the picture. But when combined with the /VX term structure you have a powerful tool that may help you stay calm when markets panic.
Open a Futures Account
For qualified accounts, you'll need Level 3 options approval to trade futures. Log in to your account at tdameritrade.com. Under the Trade tab, go to Futures & Forex for more information.