The Volatility Index or VIX is at one of its highest sustained levels since the COVID crash in early 2020 and since late February it has maintained an inverted futures curve, also known as backwardation. If you are interested in an overview of what the VIX is and how to use it then the recent post from January I did on How to Use VIX as a Market Signal would be a benefit to read. But here I wanted to summarize why the VIX term structure is inverted and what it means for trading. 

A lot of people know the VIX is a general way to measure fear in the markets but the true definition of what the VIX measures is simply the implied volatility averaged across a variety of options strikes expiring 30 days from now. The negative correlation with stocks just comes from the fact that velocity of risk is almost always to the downside for the stock market. Meaning that the sharpest more volatile moves are on the way down as people sell faster and more emotionally than they buy stock. When fear spikes, there is a rush to buy put options which protect you from falling prices. This creates a volatility skew in the SPX options that makes puts trade at higher premiums than the calls that are a similar distance away from current prices. As those prices of puts rise from buying demand seeking to protect a stock portfolio, then the VIX increases.

What is the Rule of 16?

If the VIX is trading at 16, then one-third of the time, the market expects the S&P 500 Index (SPX) to trade up or down by more than 1% (because 16/16=1). A VIX at 32 suggests a move of more than 2% a third of the time, and so on. Of course based on a normal distribution that means roughly two-thirds of the time (or 67%) the market expects the SPX to stay within the expected move of 1% for a 16 VIX, or 2% for a 32 VIX. Currently with a VIX in the low to mid 30’s to start March, we have seen several days of intraday ranges over 2%. This is a classic characteristic of a market in “backwardation” or an inverted futures curve. 

VIX Futures Curve

A normal VIX futures curve shows the front month with the lowest price on the curve and the future months 3, 6 and 9 months away with higher prices. This makes sense because generally the risks in the future going out that far should be more uncertain than today and thus they are priced accordingly. That scenario in the VIX is called “contango” and is what the market spent most of 2021 in. The graph below shows the VIX futures curve from a random day in early November 2021. It clearly shows an upward sloping VIX curve in contango, with the front month VIX at a low 18.40 and higher each month into the future going out to 240 days to expiration. This is how a normal market prices future risk.

But when near term risks rise and fear increases, it pushes the front month VIX futures higher and can sometimes become inverted where the front month is the highest compared to the back months. This is backwardation and it signals the market place is pricing in the most risk in the current month. This means that volatility intraday increases to higher levels and the stock market is generally in a downtrend with extreme movement. Many times if the market is still in a bull trend overall and has been selling off for weeks and then the VIX curve becomes inverted that’s actually a good sign to look for a bottom in stocks. But in bear markets where stocks are downtrending for months or longer, it can be a sign of persisting realized volatility and justified nervousness. You can see in the graph below comparing the VIX (1 month volatility) to the VXV (3 month volatility) whenever the ratio gets over 1.0 during the last year it’s been a good time to buy SPX. That didn’t happen often though in a strong bull market uptrend, only twice officially in 2021. The signal in late September got close at 0.97 so was enough to think along the same lines but the VIX spike in late November during the Omicron scare was a great time to buy SPX for a trade and then again at the end of January as the market put in a low the exact day January 24th as the VIX curve went inverted. 

But now what? The current VIX futures have been inverted for much of the last three weeks and the SPX is waffling around violently between 4200-4400. In bear market downtrends like the one we are in currently it becomes a risky endeavor to buy dips and try to hold for more than a day or two the same way you might have done in a bull market because with the VIX in backwardation it implies high volatility to continue and the sudden sharp rallies we see are usually bound to fail and get rejected. Simply put, when the VIX is in backwardation it means intraday ranges expand in size and velocity and the risk of large overnight gaps increases. The COVID crash in March 2020 had a steeply inverted VIX curve for about 2 months until around late April when the VIX/VXV ratio slipped back under 1.0. The green arrow shown below was the first all clear sign in the volatility markets that stocks had bottomed after that wild ride.

What to Expect When VIX is Backwardated

An inverted VIX is telling us the market is in a negative gamma state. This simply means that market makers or dealers are forced to sell weakness and buy strength. In a downtrend there is more weakness so selling begets more selling as prices fall. This creates a negative feedback loop where dealers, who hedge their risk constantly everyday to maintain delta neutrality, are natural sellers into weakness when they normally would be buyers at support. In a positive gamma environment there is stability because dealers sell into strength and buy into weakness. This ensures their exposure is neutral and flat but when the VIX inverts and gamma flips negative it expands implied volatility and the market follows. 

Overall, this matters a lot to the natural flow of trading markets because as we mentioned at the start, a VIX at 32 implies a 2% high to low trading range for the day. So when backwardation is present it’s the marketplace saying that anything and everything can and will happen. If you thought that support level was going to hold, it’s not. If you thought a stock looked good because of its chart, it doesn’t matter as much because correlations often go to 1.00 in a volatile market and the index futures rule the day. This is why I say it’s best to focus on trading the stock indexes like SPY, QQQ when volatility strikes because almost everything will move based on the index it’s a part of. 

In a backwardated volatility market, the sellers are in control and most rallies are short covering from dealers who are adjusting their hedges. Institutions are not supporting the market on the bid like they once did. This doesn’t mean there are not great trading opportunities on the long side intraday or overnight but you have to be nimble, experienced and confident. Because without the proper compass in the Amazon jungle, you will be the market’s prey. Having more realistic expectations with directional trades that might have been held for a week or two in the past, can sometimes see the same return in one day or even a few hours. There’s not much reason to accumulate positions that are all correlated either because the market can easily gap down 2-3% overnight and you will be hosed. 

Tips for Trading Volatile Markets

The best way to trade a market in backwardation is to first cut back your position sizing and then have smaller expectations for profit targets. Base hits instead of homeruns. And if swing trading, which I love to do, then it’s super crucial to trade options using spreads and more complex implied volatility strategies such as butterflies or credit spreads which take advantage of implied volatility contractions and theta decay. You can be totally wrong on the direction in the short term but still make money because you know you risked the spread and did not need to use a stop loss that is sure to get swiped during these massive moves. Also trying to maintain a downside hedge to complement any long positions you might hold overnight is a solid idea. But more importantly just being ultra disciplined to pick your spots and specific entry and exit points will help avoid the frustration of extreme volatility. As a trader you have to narrow your focus to trade well. You can’t touch all the water in the ocean. The best surfers find the best waves at the right time and ride them. This is especially true during a storm.