Trading the VIXOften dubbed the "fear index," the VIX gauges SPX options' implied volatility, typically rising during equity market declines and vice versa. It quantifies investor anxiety, demand for hedging, and market stress, crucial for traders and risk managers seeking to measure turbulence.
The VIX calculates a constant 30-day implied volatility using SPX options expiring over the next two months. Unlike simple weighted averages of equity indices, its methodology is more complex, involving implied variance calculation for the two nearest monthly expirations across all strikes. For detailed formulas, refer to the introductory chart or visit the CBOE’s official VIX Index page.
While the VIX Index itself isn’t tradable, exposure can be gained through VIX futures or exchange-traded products (ETPs) like VXX, UVXY, and SVXY. However, these instruments come with their own unique risks, pricing behaviors, and structural nuances, which can make directional VIX trading considerably more complex than it might initially appear.
What You Need to Know About Implied Volatilities
• In calm or uptrending markets, the volatility curve typically slopes upward (contango), indicating higher implied volatility with longer maturities.
• In declining or turbulent markets, the curve can invert, sloping downward (backwardation), as shorter-term implied volatilities rise sharply.
• This pattern can be observed, comparing VIX9D, VIX, and VIX3M against the SPX. In stable markets: VIX9D < VIX < VIX3M. In stressed markets, this relationship may reverse. The VIX9D and VIX3M are the 9-day respectively 3-month equivalent to the 30-day VIX.
What You Need to Know About VIX Futures
• When the volatility spot curve is in contango, the VIX futures curve will also slope upward.
• In backwardation, the futures curve slopes downward, reflecting heightened short-term volatility and short-term volatility spikes.
• While in contango, VIX futures "roll down the curve," meaning that—independent of changes in volatility—futures tend to decline in value over time.
• In backwardation, the opposite occurs: futures "roll up the curve," potentially rising in value over time even without volatility changes.
• VIX futures’ responsiveness to VIX Index movements – the beta of VIX futures against the VIX index - declines with longer expirations; front-month futures may react to 70-80% of VIX changes, compared to 40-60% for third or fourth-month futures.
Key Consequences for Traders
• Directional trading of VIX futures can be strongly influenced by the shape of the futures curve.
• Contango in low-VIX environments creates strong headwinds for long VIX futures positions, caused by the “roll-down-effect”.
• Conversely, backwardation in high-VIX environments creates headwinds for short positions.
• These effects are more pronounced in front-month contracts, making timing (entry and exit) for directional trades critical.
• There's a trade-off in directional strategies: front-month futures offer greater exposure to VIX movements but suffer more from negative roll effects.
How to Trade VIX Futures
• Due to these structural challenges, directional VIX futures trading is difficult and requires precision.
• A more effective approach is to trade changes in the shape of the futures curve using calendar spreads (e.g., long VX1, short VX2). This reduces the impact of roll effects on individual contracts.
• In low-VIX, contango conditions, a rising VIX typically leads to VX1 increasing faster than VX2, widening the VX1–VX2 spread—an opportunity for spread trading.
• While VX1 may initially suffer more from roll-down than VX2, this can reverse as the VIX rises and VX1 begins to “roll up,” especially when VIX > VX1 but VX1 < VX2.
• The opposite dynamic applies in high-VIX, backwardation environments.
• More broadly, changes in the shape of the futures curve across the first 6–8 months can be profitably traded using calendar spreads. Roll-effects and the declining beta-curve can also be efficiently traded.
How to capture the Roll-Down-Effect
One of the more popular VIX-trading strategies involves capturing the roll-down effect,, while the curve is in contango. It is a positive carry strategy that is best applied during calm or uptrending market conditions. Here’s a straightforward set of guidelines to implement the Roll-Down-Carry trade:
• Entry Condition: Initiate during calm market conditions, ideally when VIX9D-index is below VIX-index (though not guaranteed).
• Choosing Futures: Use VX1 and VX2 for calendar spreads if VX1 has more than 8-10 trading days left; otherwise, consider VX2 and VX3.
• Spread Analysis: Short VX1 and long VX2 if VX1–VIX spread is larger than VX2–VX1; otherwise, VX2 and VX3 may be suitable.
• Contango Effect: VX1’s roll-down effect typically outweighs VX2’s during contango.
• Relative Beta: VX1 shows higher reactivity to VIX changes compared to VX2, mimicking a slight short position on VIX.
• Exit Strategy: Use spread values, take-profit (TP), and stop-loss (SL); consider exiting if VIX9D crosses over VIX.
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Conclusion
Directional trading of the VIX Index—typically through futures—demands precise timing and a good understanding of the volatility curve. This is because curve dynamics such as contango and backwardation can create significant headwinds or tailwinds, often working against a trader’s position regardless of the VIX’s actual movement. As a result, purely directional trades are not only difficult to time but also structurally disadvantaged in many market environments.
A more strategic and sustainable approach is to trade calendar spreads, which involves taking offsetting positions in VIX futures of different maturities. This method helps neutralize the impact of the curve's overall slope and focuses instead on relative changes between expirations. While it doesn’t eliminate all risk, calendar spread trading significantly reduces the drag from roll effects and still offers numerous opportunities to profit from shifts in market sentiment, volatility expectations, and changes in the shape of the futures curve.
What else can be done with VIX instruments
VIX indices across different maturities (VIX9D, VIX, VIX3M), along with VIX futures, offer valuable insights and potential entry signals for trading SPX or SPX options. In Part 2 of the Trading the VIX series, we’ll explore how to use these tools—along with VIX-based ETPs—for structured trading strategies.
