Some Comments on The $VIX Futures Term Structure (Preview)

By Lawrence G. McMillan

This week, we had a customer question about the $VIX futures term structure, and I thought this might be a good time to review exactly what it is and what it means, while the market is still in a relatively calm environment. 

If you’ll recall, the $VIX derivatives are related to the implied volatilities of $SPX options.  When the market is calm, near-term volatilities – both realized and implied – are low.  Witness the $VIX chart in Figure 4.  Near-term futures are going to be low as well.  The front month $VIX future at this time is the April $VIX future.   It expires on April 19th.  So, if a market maker were asked to price options that expire on April 19th, he would probably use an implied volatility fairly close to today’s low volatility.  But if a market maker were asked to price a 3-year option, he would have no idea what implied volatility is going to be three years from now, so he would likely price it with something near the longer-term average volatility, say 23% to 25%.  In between, the various futures prices fill in along the same line between the lows of today and the higher average volatiilty 3 years out.  So the futures would price something like the pattern shown in Figure 5.  This is the typical term structure during bullish markets, and the more bullish the market, the steeper the term structure, because near-term volatility is lowest in a strong bull market...

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