Do Volatility Futures Provide Useful Information for Future S&P500 Performance?
Volatility or VIX Futures are based on the S&P500 index and are calculated from the implied volatility of different option strike prices across different expiration periods. In contrast to the VIX index, VIX Futures represent forward expectations for volatility as well as the demand for insurance against tail events in the market. Most of the time the VIX futures are in “contango” which means that the VIX futures curve is upward sloping– the spot VIX price is lower than the front month futures, which in turn are lower than the second month futures and so on.
In contrast, when the VIX futures are in “backwardation” the VIX futures curve is downward sloping– the spot VIX price is higher than the front month futures, which in turn are higher than the second month futures and so on. Currently the VIX futures are in the rare state of backwardation which raises the interesting question of what that is likely to mean for the stock market going forward.
Many traders look at either the VIX versus the front month futures contract or the front month versus the second month contract to get a gauge of whether the curve is in backwardation or contango. We can see from the table below that the volatility futures have historically spent most of their time in contango and that backwardation is relatively rare:
Traditional option pricing theory according to the Black-Scholes formula would predict that all time frames and all strikes should have the same implied volatility, and since there is no cost of carry, volatility futures curve should be flat.
So why do VIX futures spend most of their time in contango?
One explanation is that the Black-Scholes model assumes that stock returns are distributed as a gaussian or normal distribution (technically lognormal), while actual market returns exhibit fat tails. As we know, the actual frequency occurrence and magnitude of market crashes is larger than what a normal distribution would predict. This is now factored into option prices on the S&P500. Since the crash of 1987, put options have been more expensive than call options at given comparable strike prices which reflects this crash risk. Furthermore, out of the money strike prices on both call and put options show higher implied volatility which reflects these fat tails.
How does this tie in with volatility futures?
The volatility of the S&P500 can never be negative or even zero. However, it is well known that volatility rises when the market falls. Thus the VIX futures theoretically provide a good asymmetric hedge against market risk since downside is limited and upside is substantial. This means that investors are likely willing to pay a premium to buy volatility futures to have some insurance against market drawdowns. That is why the volatility futures markets are typically in contango- reflecting this cost of insurance. A recent paper by Eraker and Wu- “Explaining the Negative Returns to VIX Futures and ETNs: An Equilibrium Approach” — confirms this theory:
“We propose an equilibrium model to explain the negative returns. In this model, increases in volatility endogenously lead to decreasing stock prices. The negative return premium is an equilibrium outcome because long VIX futures positions hedge against low returns/ high volatility states (i.e, ﬁnancial crisis). VIX futures tend to rise when the S&P 500 falls — the correlation of returns is about -0.7. If there were no contango in VIX futures, everyone would buy them to get free insurance against stock market declines.”
Returning to our insurance analogy, when would we expect investors to demand more insurance?
This is where it gets tricky, since the simplest or most common answer might be that investors would demand more insurance during periods of higher volatility or bear markets. But this does not reconcile with the observed volatility curve and the higher frequency of contango– after all, most of the time stocks rise during periods of low volatility. Therefore the equilibrium explanation requires looking at the intersection of both buyers and sellers of insurance. Buyers of insurance should have greater demand as function of having higher gains on their stock positions in periods of low volatility. If we make the fair assumption that volatility is highly mean-reverting, it therefore follows that very low volatility readings are likely to revert to normal levels over time. Buying volatility futures would be a cheap way to “lock in your gains”– and nearly cost-free asymmetric hedge without paying some sort of premium. Therefore the sellers or insurers would be motivated to extract some sort of insurance premium from the buyers. Conversely, when volatility is high, there should be fewer buyers of insurance because they would not want to lock in their losses buy purchasing an expensive hedge on volatility that is likely to mean-revert and go lower over time. As a result, sellers of insurance must provide a premium to buyers to incentivize demand as implied volatility (vix) gets higher. The table below shows the frequency of contango as a function of volatility.
(source: Volatility Made Simple)
As you can see, when the VIX is very low it is highly likely that the futures will be in contango. In contrast, when the VIX is very high, it is much less likely that the futures will be in contango and instead are more likely to be in backwardation. We know that bull markets are associated with low volatility or a low VIX, while bear markets are associated with high volatility or a high VIX. Therefore we might predict that the contango regime should show positive S&P500 returns, while backwardation might show negative S&P500 returns. The tables below show how the S&P500 performs while the VIX futures curve in each regime.1
As you can see, when the VIX futures are in backwardation the market generally has negative performance. Furthermore, the longer the VIX futures remain in contango, the worse the S&P500 performance. When backwardation lasted less than 10 days, the S&P500 had mixed performance with the exception of one outlier which was the “flash crash” in May of 2010. When backwardation lasted for longer than 1 month, the average performance was a -5.6% loss for the S&P500. The biggest false signal was at the start of the new bull market in March of 2009, when the S&P500 gained 7.5%. As we will see, the VIX futures curve tends to be a poor indicator at major market turning points, but generally a good indicator during the middle of the trend. Let’s look at how the S&P500 performs while in contango:
When the VIX futures are in contango, the S&P500 tends to have positive performance- gaining on average 7.6% during this regime. Most of the instances coincide with bull market years, however there are several instances where contango occurred in 2008 and these uniformly resulted in losses for the S&P500. Most interestingly, the biggest loss occurred at the peak of the market in late 2007, this demonstrates once again that the slope of the VIX futures curve is often a poor indicator at major turning points.
Given that backwardation shows negative S&P500 performance, and that contango shows positive performance, it is interesting to see how using the VIX regime indicator would perform as a timing signal for the S&P500. This method does not use forward looking information. We simply go long the S&P500 in contango, and use cash (we assume you earn zero while out of the market to get a purer sense of the timing value) when the futures are in backwardation.
The VIX futures timing strategy shows superior returns and risk-adjusted returns to a simple buy and hold strategy holding the S&P500 (SPY). The sharpe ratio is nearly double the buy and hold sharpe ratio which shows that you can earn higher returns with much lower risk by paying attention to the market regime for the VIX. Furthermore the maximum drawdown is nearly half of buy and hold, which means that the ride would have been a lot easier to handle for investors. However, it is important to note that this drawdown occurred as the market transitioned into a bear market from 2007 through early 2008.
So where do we sit currently with the term structure?
(as of Feb 19, 12pm EST, source: vixcentral.com)
Currently, we sit in contango based on the graph above, but clearly the term structure across months is quite flat. We recently came out of a backwardation regime that started near the beginning of 2016 which turned out to be a good timing signal. Does the current contango indicate that we should be bullish on the S&P500 going forward? I think that the answer at this point is much more neutral. The S&P500 sits below its major trend and is demonstrating negative momentum. The presence of contango in this case contradicts the major trend. Recall that VIX futures slope indicator tends to have poor signals at market turning points. Since we have recently tested major multi-year lows for the first time, we may very well be at one of those turning points. This probably indicates that we are undergoing a consolidation within the current trend. In either case, the performance of the S&P500 in contango shows more reliable positive performance the longer the regime tends to last. At this point since we have only been a few days into contango, the future is more uncertain.
In summary, we believe that the VIX futures are a good resource for investors, and the slope is a good indicator for dynamic asset allocation. Perhaps it works best as a confirming indicator alongside a momentum or trend-following strategy which is a subject for future research.
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