When it comes to the confluence of factors affecting the pricing of the various VIX ETPs out there, a critical component any trader in these products needs to understand is the term structure of VIX futures. Where the term structure is currently priced at will have a sizable impact on the performance of his ETP of choice going forward. By the term structure, we are talking about the relationship of futures contracts on the VIX with different expiration dates relative to spot VIX. When you string the prices of the various futures expiries in order out into the future, you have your term structure. Below is the futures term structure from the close last Thursday, March 28.
The most immediate feature of the above term is that all futures prices are above the current spot VIX, with futures price an increasing function of time. This is referred to as a futures market in contango. By comparison, a market where the opposite is true is in a state of backwardation. In that condition, futures prices will be below spot VIX as a decreasing function of time. The term structure need not be in either one of these states exclusively. There can be instances where the curve becomes kinked or humped on the front end, usually in periods of transition from a state of pure contango into pure backwardation and vice versa. The below chart shows such an effect in the VIX futures curve during late July and early August of 2011 as equity markets rocketed into high volatility land from an extended period of low volatility.
To understand why knowing the term structure really matters, you need to consider the trajectory that the price of a futures contract will follow as it nears expiration. Since the final settlement of the futures contract is based on the value of spot VIX on the expiration date of the futures contract, the futures price must naturally converge to spot VIX by contract expiration. In cases of contango, this implies that the futures price must fall down to spot VIX by expiration and vice versa during backwardation. The implication of this statement is that for holders of the long VIX ETPs, you are paying the market to hold your position on any given day while the market is in contango. The flip-side is that the market pays you to hold your position when it is in backwardation. And for those keeping score at home, the double-long products are paying the market twice as much to hold their positions during contangoed(?) markets. I believe I just made up a word.
Since there are no shortage of articles (from myself included) that show you why VXX or UVXY fail miserably at replicating VIX exposure when the market is in contango, let me give you an example of why these products are remarkably effective at not only replicating VIX exposure during periods of backwardation, they actually beat the VIX handily during such times. The graphic from above depicts shifts in the term structure during late third quarter of 2011. During a two month stretch, the term structure was in full backwardation as markets swung wildly, including an October that registered one of the largest single monthly gains in stock market history. How did VXX and double-longs like TVIX do in comparison to the VIX? Take a look at the chart below.
If you are still wondering why the term structure matters for VIX ETPs, this chart should be giving you the exclamation point to your aha moment. Between August 4 and October 25, the term structure had gone through an extended period of backwardation. There can be some subjectivity in how one defines the term structure and what futures months one chooses to look at (some may argue it did not fully revert until early November), but I chose October 25 more because it marks a period where the VIX itself was essentially unchanged relative to August 4. Over the period, the VIX was up 1.8% while VXX and TVIX were up 51.6% and 79.8% respectively. Please let that sink in.
The analogy I will use is that the term structure is like a strong river current: it’s hard to see its effects on any single day, but give it enough time and it can create some powerful outcomes. The Grand Canyon was created over thousands of years of river currents…and so too has VXX created gaping holes the size of the Grand Canyon in investor portfolios that don’t pay attention to the term structure while it’s in contango.
Another chart I’d like to show is the price dynamics that enable these type of outcomes to happen. Below you will see the relationship of the VIX to the front-month VIX future for the period I just mentioned in 2011. Over this period, spot VIX was over the front-month future essentially the entire time. Remember what I said earlier about the price trajectory of a futures contract as it nears expiration. During market conditions like this, the VIX is essentially “pulling up” the futures price as long as it remains above the future. And you can see here, the point spread over several days was pretty substantial…to the tune of 10+ VIX points. This phenomenon is referred to as the roll yield for the futures contract. The futures price is “rolling up” the backwardated(?) futures curve to the spot price. Another fabricated word, boom.