The Impact of VIX Contango and Backwardation on Call Spreads

Impact of Contango and Backwardation on VIX Futures and Options

In the intricate ecosystem of volatility-linked products, no concept is more fundamental or has a more profound impact on long-term performance than the term structure of VIX futures. The shape of this curve—whether it is in contango or backwardation—is a important determinant of the profitability of any strategy that involves holding VIX futures or options over an extended period. For the professional trader engaged in tail-risk hedging, a deep and quantitative understanding of the term structure is not merely an intellectual curiosity; it is an essential component of successful strategy implementation and risk management.

This article will provide a rigorous examination of contango and backwardation in the context of the VIX futures market. We will dissect the concept of "cost of carry" and explain how it creates a persistent headwind or tailwind for VIX-based strategies. We will then analyze the specific impact of the term structure on the pricing and performance of VIX call spreads, demonstrating how the choice of expiration date can either mitigate or exacerbate its effects. Our objective is to move beyond a superficial understanding of these concepts and to provide the professional trader with a practical framework for navigating the complexities of the VIX term structure. By the end of this discussion, the reader will be equipped to make more informed decisions about the timing and construction of their VIX hedges, ultimately leading to more effective and cost-efficient portfolio protection.

The VIX Futures Term Structure: Contango and Backwardation Defined

The VIX futures term structure is simply the relationship between the prices of VIX futures contracts with different expiration dates. It can exist in one of two primary states:

• Contango: This is the "normal" state of the VIX futures market, prevailing for the majority of the time. In contango, longer-dated VIX futures trade at a premium to shorter-dated futures, and the entire futures curve trades at a premium to the spot VIX index. This upward-sloping curve reflects the market's expectation that the VIX, which is a mean-reverting index, will eventually rise from its current level to its long-term average. It also reflects a time premium, as there is more uncertainty associated with the VIX over a longer time horizon.

• Backwardation: This is a less frequent but critically important state of the VIX futures market, typically occurring during periods of high market stress and fear. In backwardation, shorter-dated VIX futures trade at a premium to longer-dated futures, and the front-month futures contract can trade at a significant premium to the spot VIX. This inverted, downward-sloping curve reflects a high current demand for immediate protection and the market's expectation that the VIX will eventually decline from its improved level.

The 'Cost of Carry' in VIX Hedging

The state of the VIX futures term structure has a direct and significant impact on the performance of any strategy that involves holding VIX futures or VIX-related ETPs. This impact is often referred to as the "cost of carry" or the "roll yield."

In a contango market, a long position in VIX futures will experience a negative roll yield. This is because as a futures contract approaches expiration, its price will tend to converge towards the lower spot VIX price. To maintain a constant maturity exposure, a trader must sell the expiring front-month contract and buy the more expensive next-month contract. This process of "rolling" the position results in a small but persistent loss, which can significantly erode the value of the position over time. This is the primary reason why long-VIX ETPs like VXX and UVXY have a strong tendency to decay in value over the long run.

In a backwardated market, the situation is reversed. A long position in VIX futures will experience a positive roll yield. As the front-month contract approaches expiration, its price will tend to converge downwards towards the spot VIX, but the trader can roll their position to a lower-priced back-month contract, resulting in a profit. This is why backwardation can be a effective tailwind for long-volatility strategies.

Impact on VIX Call Spreads

The VIX futures term structure also has a significant, albeit more nuanced, impact on the pricing and performance of VIX call spreads. The prices of VIX options are intrinsically linked to the prices of VIX futures, as the futures curve represents the market's expectation of the future path of the VIX. Therefore, the state of the term structure will influence the premiums of the long and short call options that constitute the spread.

In a contango market, the upward-sloping futures curve will tend to inflate the prices of longer-dated VIX options relative to shorter-dated ones. This means that a VIX call spread with a longer time to expiration will be more expensive than a similar spread with a shorter time to expiration. The choice of expiration date for the spread is therefore a important decision. A trader who is concerned about the negative carry from contango might opt for a shorter-dated spread, even though it will require more frequent rolling.

Conversely, in a backwardated market, the inverted futures curve will tend to depress the prices of longer-dated VIX options relative to shorter-dated ones. This can create opportunities for traders to establish longer-dated hedges at a relatively low cost. However, backwardation is often a sign of high current market stress, and the premiums of all VIX options will be improved in such an environment.

The professional trader must be acutely aware of the VIX term structure when constructing and managing a VIX call spread. The shape of the curve will influence the cost of the hedge, the optimal choice of expiration date, and the economics of rolling the position.

Mathematical Framework: Calculating the Roll Yield

The roll yield can be calculated as the percentage difference between the prices of two consecutive VIX futures contracts. A simplified formula for the roll yield is as follows:

Roll Yield = (F2 / F1) - 1

Roll Yield = (F2 / F1) - 1

Where:

• F1 is the price of the front-month VIX futures contract.
• F2 is the price of the second-month VIX futures contract.

A positive roll yield indicates a contango market, while a negative roll yield indicates a backwardated market.

The following table illustrates the VIX futures term structure in both contango and backwardation, and its impact on a hypothetical 30-day VIX call spread (20/25 strikes).

This table demonstrates how the cost of the VIX call spread is influenced by the state of the term structure. In the contango example, the spread is relatively cheap, but a long position in VIX futures would be subject to a negative roll yield. In the backwardation example, the spread is more expensive due to the improved VIX, but a long position in VIX futures would benefit from a positive roll yield.

Conclusion

This article has provided a detailed analysis of the important role of the VIX futures term structure in the performance of VIX-based hedging strategies. We have seen how contango creates a persistent headwind for long-volatility positions, while backwardation can provide a significant tailwind. The professional trader who ignores the term structure does so at their peril. A failure to account for the cost of carry can lead to a steady erosion of capital and a hedge that is far less effective than anticipated. The key takeaway is that the VIX term structure is not a static given; it is a dynamic and effective force that must be constantly monitored and incorporated into the decision-making process. By understanding the nuances of contango and backwardation, the trader can make more informed choices about the timing, construction, and management of their VIX call spreads, ultimately leading to more robust and cost-efficient portfolio protection. In the next article, we will address the important question of portfolio allocation, exploring how to size a VIX call spread hedge for optimal protection.