The VIX, or the ‘implied’ 30-day volatility of the S&P 500 derived from call and put options, represents the probable range of movement in the S&P 500 above and below its current level in the immediate future. Taking the VIX close on Wednesday, March 25, 2020, as an example, the number 63.68 can be interpreted as indicating that over the next 30 days, there is a 68% chance that the S&P 500 will be trading within a range of ±18.4% (equivalent to an annualized range of ±63.68%) from its current level. In terms of S&P 500 levels, this range spans from 2020 to 2930, based on Wednesday’s closing value of 2475.
The VIX term structure refers to the relationship between VIX futures prices and their respective maturity dates. It is described as being in ‘Contango’ when VIX futures are priced higher than the VIX spot and ‘Backwardation’ when the relationship is reversed. The term structure curve can also take the shape of either being concave upward or concave downward, depending on whether mid-term futures prices are closer to short-term prices or long-term prices.
In January and early February, the stock market seemed unaware of the imminent crash. The VIX started the year at 13.78, and its term structure exhibited the classic Contango with a concave downward shape. When the coronavirus outbreak hit China, the VIX spot slightly elevated to 17.97 on February 3 due to concerns about supply chain disruptions and a global economic slowdown. However, the VIX term structure remained nearly flat (as indicated by the green line in the chart below), suggesting that the market wasn’t significantly concerned. The curve returned to its classic shape on February 19, 2020. (Note that there’s a bump in the back end for all three curves, which is because VIX futures prices tend to be higher around the time of the presidential election.)
Then, the sell-off began on February 20. From February 21 to 28, the VIX term structure rapidly transitioned from Contango to Backwardation as the VIX spiked and moved ahead of the futures prices. However, the increases were relatively small, primarily occurring in the front end (as seen in the cluster in the chart below), indicating that investors believed the episode would likely be nothing more than a temporary hiccup.
Entering March, major indices experienced their fastest declines in history. The VIX surged to 81 on March 16, and its term structure displayed severe Backwardation with all futures prices moving up across the time horizon (as indicated by the blue line in the chart above). The message it conveyed was clear: the stock market could exhibit extreme volatility in the near term, and even six months out (180 days), the potential range of movement for the S&P 500 could be as wide as ±32% annualized.
What’s interesting is that from March 16 to 23, during Backwardation, the VIX futures curve changed from being concave upward (indicated by the black line) to concave downward (indicated by the green line in the chart below). This change occurred as the front end dropped along with the spot price, while the mid and back ends remained consistent. By comparison, the 30-day to 90-day futures were priced significantly lower relative to the VIX spot during the financial crisis on October 16, 2008 (as shown by the blue line). This concave downward shape we are currently observing suggests that it may take some time before the VIX drops below 40, and uncertainty could linger over the stock market for longer than what was predicted on that particular day in 2008.
Like the stock market itself, VIX and its term structure change every day, if not every moment. When new information arrives, investors collectively update their views and expectations regarding the market’s direction.
(All charts are from vixcentral.com)