Condor Options

The term structure of VIX futures is best approached not as an actual forecast of market volatility but as a complex measure of uncertainty, historical tendencies, and demand in S&P 500 options markets. A significant amount of the persistent contango in the VIX futures term structure is just a feature of the positive relationship between uncertainty and time.

FT Alphaville’s Izabella Kaminska wonders whether the steep contango in the term structure over the last year has diminished the credibility of the futures as a forecasting tool:

The conventional view is to see this as the market pricing in — or even forecasting —more volatility in the months to come.

The problem is that over the last year or so the Vix futures curve has proved particularly bad at forecasting volatility this way.

As one Vix market maker told FT Alphaville recently:

Since about March 2009 long-term volatility assumptions have been much much higher than actual volatility.

Not only does that discredit Vix futures as a forecasting tool, it suggests some pretty shoddy pricing on both the part of the Vix futures market and S&P options market.

I wouldn’t regard VIX futures or S&P 500 options as making market predictions: if that’s the conventional view, the conventional view is wrong, and there I agree with Kaminska. But I also wouldn’t regard the options markets as having priced contracts poorly. A VIX futures contract several months out carrying a higher price than the spot index or one-month contract is no more remarkable – and no more an actual market prediction – than the utterly mundane fact of at-the-money options with several months to expiration being priced at higher implied volatilities than ATM options with just one month to expiration. Any longer-dated contracts have more uncertainty associated with them: more can go wrong in six months than can go wrong in one. That uncertainty is reflected in higher implied volatility, which means higher prices for options and VIX futures contracts.

If nothing exciting happens between today and six months from now and the market ascends in a straight line, it will look like those options and futures were overpriced, but that conclusion is only possible from the epistemically superior ex-post standpoint. Any perceived shoddy pricing in these derivatives over the last year is, therefore, just a function of ordinary uncertainty and of the unusually strong and uninterrupted market ascension.

I don’t understand the warrant for the claim in the last part of her post, about the possibility of VIX futures wagging the tail of the S&P 500 options markets. Volume in the VIX futures has grown dramatically, but it is still dwarfed by the S&P complex under any measure – especially once you include the SP and ES futures options and the SPY options. Total open interest in the VIX futures complex at this time is 164k; in months 5-8 (Jul-Oct), the total open interest is just 41,197. Liquidity in the VIX back months is just fine for trading and hedging, but at this time I think it is impossible for the VIX futures to do anything but supervene on the action in S&P 500 options.

Homepage photo courtesy of Flickr user mag3737.