Recently – in the sharp market drops of 2015 & 16, February & Dezember 2018 and March 2020 – using the VIX Futures term structure as a warning indicator has successfully protected my portfolio from painful losses. 

Since 2018 the nature of stock market drops seems to have changed. We see sharp declines followed by strong reversal rallies, a V-bottom, much more frequently than they used to occur. Common tactical asset allocation models based on long-term trend have a really difficult time dealing with this: the protective exit and the re-entry are late in such fast moves causing significant underperformance.

A danger signal based on the term structure of VIX futures on the other hand reacts more dynamically and triggers a warning earlier in a market displaying significant changes in volatility.

What is the VIX Futures Term Structure?

VIX measures the expected volatility of the S&P 500 over the next 30 days and cannot be traded. Futures contracts based on the VIX are tradable and have an expiration date. Different expirations of these futures contracts trade at different prices, the sequence of which is called the term structure.

In normal conditions people expect a larger range of possible price moves and volatility levels the more time passes – a very simple and rational concept of expecting higher uncertainty for a future that is farther away. This is expressed in the price of VIX futures: the longer in time they have until expiration the more people are willing to pay for them. This results in a specific futures term structure describing „normality“ – the term structure is in contango.

This structure is very stable, because VIX futures can be used to hedge against stock market crashes ensuring a steady demand: because VIX shoots up in a crash hedgers buy VIX futures for protection and pay a premium over the current value of the VIX for this insurance. There is no free crash protection in a functioning market as everyone would then buy it thereby bidding price up.

Opportunity and hidden risks in a low volatility market environment
2017 was a prime example of a whole year (from April 17 to Feb 18) with the term structure in contango. Anyone using risky strategies that were explicitly or implicitly short volatility made a lot of money.
For example, the purest short vol trade, selling VIX futures, would have netted more than 10% in roll yield per month (you can see in the table above that the 2nd month future was priced 13% higher than the first in October 2017 – if nothing changes this is the profit you make being short the 2nd future as its price moves down to the price of the 1st month future over 30 days). 
In fact that is what more and more people started doing. This at first further suppressed volatility and a large, unstable volume of short VIX futures contracts was built up – until it exploded in the infamous „Volmageddon“ in February 2018. A small spike in VIX caused too many traders to cover at once leading to a chain reaction of spiking volatility.

Whenever things are not normal risks and danger rise and using the Vix futures term structure to signal such shifts in the market environment has worked great in the past.

How to use the indicator

The basic idea is very simple and based on the premise that distinct market regimes tend to stick around for a period of time: in a normal environment taking risks and running risky strategies (e.g. short volatility strategies or leveraged equity exposure) is likely to be rewarded. 

“Not normal” is dangerous and can be defined by a volatility structure that is breaking the rules: if market participants pay more for VIX futures contracts that expire soon than for those that have months to run, something is amiss. Volatility is expected to be very high in the near future – a market crash is seen as a likely outcome by many investors and it pays to be careful.

Usually one of two things will happen when we see a term structure inversion:

• The market is undergoing a severe, but temporary scare, that quickly resolves and the term structure returns to normal.
• A serious disruption is causing the term structure to invert and the warning signal is triggered in the beginning of a large market drop.

Setting warning thresholds

As with trend signals, an important decision is choosing the threshold for the indicator: a small term structure inversion triggers early and often, avoiding much of the first drop in a beginning crash, but also signaling frequent false warnings. A strong inversion reliably foreshadows a difficult market environment, but sits through more of the initial market decline.

For my own models I have settled on using the indicator in two stages (these are levels derived by backtests and practical experience):

• I filter out the smallest inversions which are often temporary and use a difference between the first VIX futures contract (with at least 5 days to expiration left) and the second of -1,5% at the daily market close as a sensitive warning signal.
• We are in a severe disruption when the inversion lasts for at least one week or reaches more than -9%. At this point all risky trading activity and assets should be reduced to a minimum.

The indicator in practice

I have used a variation of term structure signals in trading and investing since 2016 (on vixcentral.com you can find the current contango values and a graph of the current term structure).
Here is how the signals as defined above played out in recent years:

After a long period of severe market disruption with an inverted term structure in the Great Financial Crisis we saw many sensitive warning signals (short red arrows) and, significantly, a few very strong signals (long red arrows) in 2011, 2015, 2018, 2019 and 2020 each signaling a disruptive market period early on. 
The analysis above was done in early 2019 and is therefore not over-optimized to recent market events. 

Let’s zoom in and include the most recent period in more detail:

Strong signal clusters preceded each of the major market disruptions in recent years and provided great opportunities to scale down risk.

My personal takeaway
I will tread very carefully whenever I see a VIX term structure inversion: a volatile market environment usually follows. With a strong signal the probabilities for severe market disruptions rise significantly. As preserving capital is essential for an active investor & trader, I reduce all exposure to risky equity strategies to a bare minimum for a period of several months – specifically any short volatility exposure. 

Good luck in your trading & thank you for reading!

David

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