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Back to the VIX Futures

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Since they're lagging, now's a good time to refresh your memory as to how they work.

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With the volatility of the VIX itself exploding the last few days, and VXX and VIX futures somewhat lagging, what better time to refresh our knowledge of how these pups work?



By "volatility of the VIX," I mean the degree to which the VIX itself is moving. It rallied 20% on Thursday, than lifted another 10% Friday before closing flattish. That's volatility of volatility for you.

VIX futures "bet" on a snapshot of where the VIX will close on the day they expire. That expiration is 30 days before the next month's SPX expiration, so February VIXes expire on February 17, March VIX on March 17.

Since February VIX has gotten pretty close, let's stick with March for this discussion.

If you buy a VIX March future, you're betting on where the VIX will close on March 17. It settles pre-open, so fear not if you have other plans for St. Patty's Day. It speaks nothing of what the VIX does between now and then. A VIX move today will translate somewhat into a move in March, but not fully. That's because the VIX itself is a mean-reverting instrument; it lifts abruptly with fear and then reverts back quickly (most of the time) as the fear abates. A VIX future will generally assume short-term blips will reverse, and thus price accordingly; in other words, not rally fully with a VIX lift. The longer dated the future, the less it will react to VIX blips.

Futures with similar time until expiration as the March has now (about 40 days) have traded with premiums to the VIX itself for the better part of the last nine months. I don't know the exact number, but it's generally been in the 3-5 point range. Until two weeks ago, that bid-up was consistently wrong. The market stayed non-volatile, and the future eventually drifted lower to the level of the actual VIX.

But then mid-January came, and volatility actually perked up. The VIX has rallied about 50%, but the futures, not nearly so much. That's because they pre-anticipated this pop, and now are roughly in line (and even at a discount for stretches).

What I'd avoid doing going forward is assigning enormous predictive value to the futures. Just consider them a slow-velocity VIX tracker. They assume every move is an aberration -- it's really as simple as that. Some VIX moves do, in fact, revert, but some don't. Take 2008, for example. VIX futures traded at larger and larger discounts to the VIX itself. Using them to "time" the market proved disastrous. You had to withstand an insane amount of pain before finally proving correct. Or take 2009 as an example in reverse. The VIX premiums to "cash" were wrong until January 2010.

Simple VIX deviation from it's 10-day MA works better. Again, not all moves revert, but it's a better gauge, in my opinion. We closed near 10% above the 10-day SMA on Friday, modestly bullish but far from remarkable (we were 43% above a couple weeks ago).
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