Vol Whisperer: Now, About those /VX Moves

Futures on the CBOE Volatility Index (VIX) are becoming more popular with futures traders because they’re direct plays on the market’s volatility, or “vol.” And if you’ve traded /VX futures, you’ve likely run into the /VX basis. That’s the difference between the /VX future’s price in one expiration, say February, and the /VX future’s price in another expiration, say, March. You have to be familiar with the /VX basis, especially if you want to roll a /VX position from one expiration to the next, or when you’re deciding which /VX expiration to trade. To the untrained eye, the /VX basis can be confusing, so let’s give your eyes a little training and kick the confusion to the curb.

It’s a Little Unique

For other futures products, like /ES on the S&P 500, or /ZB on Treasury bonds, the basis is determined by the cost of carrying a position in the underlying. But the basis in /VX futures doesn’t have a carry component. There isn’t an underlying VIX to buy, which means there’s no arbitrage relationship that keeps /VX futures in different expirations in line. They’re free to move up and down. The confusion arises when one /VX is going up, while another’s going down. Why can that happen? 

Calculating the basis can be relatively simple. First, subtract the price of the front-month /VX future from the price of the back-month /VX future. For example, if the February /VX future is trading for $13, and the March /VX future is trading for $14.20, the Feb–Mar /VX basis is $14.20 – $13 = $1.20. In this case, the $1.20 basis is positive, and it’s in contango.

If the Feb /VX future is $14, and the March /VX future is $13.50, the Feb–Mar /VX basis is $13.50 – $14 = $-0.50. The basis is negative (the back-month future is trading for less than the front month), and it’s in backwardation. The /VX can go from positive to negative and back again. But what does it mean?

Gauging the Market’s Expectations

Remember that the /VX future is the market’s expectation of what the VIX might be at the future’s expiration. And the VIX itself is the market’s expectation of what the volatility of the SPX might be over the next 30 days. So, the /VX can be thought of as a “future on a future.” As such, the /VX basis can indicate when in the future the market “fears” a potentially big price drop in the SPX. The market may be more fearful in the short term, narrowing the basis. Or in the long term, widening the basis. The /VX basis reflects the market’s opinion of what volatility might be at different points in time, which is why it can have big swings in price. 

If the market anticipates a crash in the S&P 500 in the short term, the front-month /VX will possibly rally, maybe more than the back-month /VX. So the /VX basis will narrow, or may even go negative. This can happen quickly, sometimes intraday. Alternatively, if the market anticipates more volatility in the longer term, then the back-month /VX will possibly be higher than the front-month /VX, causing the basis to widen. If you’re bullish on the /VX and don’t have a specific time frame, you might consider buying the front month if the basis is very wide, or the back month if the basis is narrow or negative.

The narrowing and widening of the basis can be exacerbated close to the /VX expiration, when it converges with the VIX. For example, if the VIX rallies sharply right before /VX expires, the front-month /VX can rally sharply, too, and in a day the basis can go from positive contango to negative backwardation. That’s why it’s very risky to be short the front-month /VX, even if you’re long the back-month /VX in a calendar spread. It’s also why if you want to speculate on a rally in /VX, it could be advantageous to buy the front-month /VX if you think the selloff will happen quickly. On the other hand, because the price of the front-month /VX is usually higher than the VIX index, the front-month /VX can lose a lot of value quickly close to expiration, if it converges to a falling VIX. So, the front-month /VX future tends to be more volatile than the back month, and is often what drives the price of the /VX basis.