As the Vix and More blog duly noted last Friday, not only has spot Vix been spiking in its own right (last print seen around the 40 mark on Monday), the entire Vix term structure has flipped into backwardation over the last 10 trading days:
Furthermore, the latest data from the CBOE shows the backwardation has only intensified over the weekend:
So how important a development is this?
To find out we inquired with Christopher Cole, managing partner at Artemis Capital Management — a volatility focused hedge fund. Readers might remember Cole from his “The great vega short” and “Is volatility broken?” research notes on volatility.
Cole explains it simply. Using statistics.
As he explained to FT Alphaville:
In regard to VIX futures curve backwardization since 2004 the front two contracts of the VIX futures curve have traded at a discount to spot VIX approximately 25% of the time. Currently the entire VIX futures curve shows inversion and this shape has only occurred 13% of the time since 2004. Negative convexity across the entire curve usually only occurs during systemically important shock events such as the 2008 financial crash, Bear Stearns bankruptcy, 2010 flash crash, and the 2007 credit market meltdown.
It is important to understand the fundamental and structural dynamics underlying VIX futures curve inversions. The traditional explanation is that VIX futures curve backwardization implies the market’s expectation of volatility mean reversion or that the VIX will decline from elevated levels. An alternative explanation is structural, implying that investors who bought VIX futures and options as tail risk insurance are now all rushing to “cash-in” on the payout at the same time, artificially pushing the curve downward.
This may explain the mixed forecasting record of the VIX futures curve in backwardization as the spot VIX has breached the discounted VIX futures price to expiry only 62% of the time since 2004. The average duration of a VIX futures curve backwardization is only 4 days, however when the entire curve in backwardization implying a systematically important event, the curve can exhibit negative convexity for much longer periods including 64 consecutive days of full curve inversion during the 2008 financial crisis.
Which means, the longer the curve stays backwardated, the more likely we’re seeing a “systemically important shock event”.