Hey Traders,

The Cboe Volatility Index, or VIX, had a wild week, with a range that spanned from sub-20 … to close on Friday over the 28-handle!

One week hourly chart of VIX

As unpredictable as the market is … you could argue that VIX is even more wildly unpredictable!

However … that does not mean it is impossible to trade.

Far from it, in fact.

But before you go out buying VIX calls or VIX puts, you will want to know some very important facts about VIX options …

And how playing VIX profitably may not be quite as difficult as you might think.

First, let’s take a look at the VIX itself. 

In the simplest terms, VIX measures expected market volatility.

It essentially reflects investor expectations of market volatility over the next 30 days by looking at implied volatility (IV) in S&P 500 (Ticker: SPX) options.

When traders are more uncertain about what’s coming, they tend to hedge, driving up demand for SPX options, and therefore driving up the implied volatility being priced into SPX options.

We could take a very deep dive into the nuances of exactly how the VIX is constructed, but we’ll save it for another time.

What is important to remember is that the VIX itself is not a tradeable – it is an index, not an asset.

And yet … you may have heard of people trading VIX options (especially yours truly!) …

So how is that possible?

There is such a thing as VIX options, but they are actually based on VIX futures rather than the VIX itself. These futures represent where the market thinks volatility will be at various points in the future.

By the time the front-month future expires, it must be equal with the VIX index itself … but until the date of expiration, VIX futures can move rather independently of the VIX index … and each other.

While VIX futures are correlated with one another, they are not necessarily tied to each other.

The relationship between VIX futures and between VIX futures and the VIX itself can be mapped on what we call a futures curve.

Here is the VIX futures curve from Monday, two days before VIX expiration on Wednesday morning:

Notice how the front-month future – the April future – is very near the VIX itself. As you move down the curve, futures further out steadily rise in value.

The shape this creates – with futures trading progressively higher over spot VIX – is called contango.

The VIX futures curve is usually in a contango formation … about 80% of the time in fact.

This tells us that traders are more worried about the future than they are about right now.

But what happens when the opposite is true, and traders are more worried about near-term volatility than volatility farther out?

This typically occurs after the VIX has popped higher, and the futures curve enters backwardation.

For example, take a look at the VIX curve from February 24, the day that Russia invaded Ukraine:

On that day, the VIX spiked, and traders became more concerned about hedging against risk NOW, rather than the risk months in the future. 

You can see that the front-month future is the highest, and the futures trade progressively lower beneath spot VIX.

What do these futures curve formations have to do with trading VIX?

Well, everything, really.

As I mentioned before, by the time each future reaches expiration, it must be equal to the VIX itself. This is called convergence.

And remember that VIX options are based on VIX futures, rather than VIX itself.

Therefore, if VIX futures are in a contango formation, as we near expiration, we can expect the front-month future to fall.

Just take a look at VIX futures in the four trading days ahead of April expiration, which took place this past Wednesday.

See how the front-month future gets lower as we near expiration?

So if you are going to trade VIX options … it seems that betting on futures to go down is likely the way you want to go, right? Shorting volatility in these instances is more likely to be profitable.

Now, when the VIX is in backwardation, that means that the front-month future actually needs to rise to meet VIX cash.

Therefore, you would want to be long volatility when the VIX curve is in backwardation.

Of course, if we have learned one thing over the past two years, it’s that volatility is – shockingly! – quite volatile.

A big spike up or down can ruin even the most well-planned trades.

Proper money management is paramount when trading VIX …

And if you plan to use VIX exchange traded products (ETPs), which also track VIX futures rather than VIX itself, then it is absolutely critical that you are aware of their features, shortcomings, and dangers.

But when done correctly, being familiar with the VIX futures curve and how VIX futures work can be very profitable indeed!

Your Only Option,

Mark Sebastian