VIX Term Structure Explained | Volatility Trading Concept

[@JK-cm3jc]

Hi Chris, question about the backwardation concept- when VIX is high and you short it with a bear call spread you mentioned the trade would still lose money if the VIX remains high at the same level when the trade was entered but what if the short strike selected on the spread was OTM? Even if the VIX remained high closer to exp date as long as the short strike was OTM it would expire worthless right?

[@gandalfwannabe1]

Very clear, very helpful. Thank you.

[@projectfinance]

You're welcome! I'm glad you found it helpful. -Chris

[@joannahuc1318]

Great explanation. Will have to watch it again

[@projectfinance]

Thank you! Repetition is important when learning

[@bmwman5]

Good one, liked it! But how are the future VX numbers derived at?

[@projectfinance]

Thank you! The answer is pretty complex. The short answer is that VIX futures prices are derived from the marketplace, which means buyers/sellers trading the futures is what determines the "equilibrium" price for each VIX futures contract. Since a VIX future will be equal to the VIX Index value at the time of settlement, you can say a VIX futures price represents the market's expectation for the VIX Index at the time of each respective futures contract's settlement date. However, VIX futures prices have a relationship with the implied volatility level observed in each SPX option expiration, which is because VIX futures settle to the VIX Index and the VIX Index tracks one-month SPX option prices. I'd check out this blog post if you're interested in reading about this: www.investinvol.com/single-post/2017/07/11/Contango-And-Cash---More-About-The-VIX-Term-Structure -Chris

[@IvanVesely920]

And when you say bullish/bearish volatility trade that means...? Thanks!

[@TheFedosso]

Why is it so common to see people staying "always short" on vix futures? What's the best hedge when shorting the vix futures?

[@projectfinance]

Most of the time, VIX futures contracts trade at a premium to the VIX Index (a condition called "contango"). As time passes, VIX futures contracts converge towards the VIX Index, as a VIX future with no more future has to be equal to the VIX. Now, when the VIX Term Structure is in contango, the VIX futures contracts must decrease in price to converge with the VIX Index (assuming the VIX Index remains the same). The negative price action of the VIX futures contracts translates to steady profits for short VIX futures traders. So, a trader would most likely "always be short" VIX futures to take advantage of the frequent decreases in near-term VIX futures prices. However, keep in mind that short VIX futures positions are very risky, as the losses on one contract can be substantial if the VIX surges. For example, one might short a VIX future at 14 when the VIX is at 12. If the VIX remains at 12, the VIX future will slowly trade towards 12 as its settlement date approaches, which means it will lose 2 points ($2,000 profit per short VIX future) if the VIX Index does not rise. However, if a trader shorts a VIX future at 14 and the VIX Index spikes to 30, then the VIX future will converge towards 30 as its settlement date nears. The trade would result in a 16 point loss ($16,000 per short VIX future). To hedge a short VIX future, long VIX calls or short E-mini S&P futures can be used. Using VIX call options would be a much cleaner hedge. Ten long VIX calls in the same expiration cycle as the future (e.g. long June VIX calls to a short June VIX future) would be needed to completely hedge the risk of one short future above a certain price. For example, if a trader shorts a VIX future at 14 and buys 10 VIX calls with a strike price of 15 in the corresponding expiration cycle, then the short VIX future's risk is capped at 15. I hope this helps! -Chris

[@azracaylana9135]

very nicely explained, thank you!

[@jgfunk]

Well, on Feb 20, 2018 there will be no more XIV...

[@projectfinance]

jgfunk, you are correct!