VIX futures tend to trade in contango (with spot trading at a discount to futures contracts). The VIX curve usually only moves into backwardation (with nearby expirations trading at a premium to later maturities) if the market is under extreme stress. It’s a relatively rare condition, but appeared during the first half of March and again last Friday. Brett Friedman of Winhall Risk Analytics/OptionMetrics Contributor breaks down VIX backwardation, and what it can potentially mean for the market.

Although the VIX is often cited as the market’s fear or anxiety gauge, the shape of its futures curve is often overlooked. The futures term structure, or the curve displaying the relationship of different contracts and maturities to one another, is the most important feature that separates futures from other financial products. Depending upon the specific product, the overall shape of a futures price curve may be used to infer valuable information, including storage costs, supply/demand factors, or, under certain conditions, short-term market direction.

Futures curves may be described using their overall shape and slope. When nearby expirations are trading at a premium to later maturities, the futures curve will be downward sloping, or backwardated (sometimes known as inverted). The reverse -- spot trading at a discount to futures contracts – is known as contango. For commodities that can be stored, that is usually the case. 

For cash-settled financial products, such as VIX futures, the shape of the curve is determined mostly by sentiment, the value of the VIX index itself, and the direction of the nearby contracts. During uncertain times, or in the case of real or possible market declines, backwardation can occur because traders naturally concentrate on current market conditions and crowd into the nearby contracts, thereby bidding them up in relation to longer-term expirations.

As you can see from the distribution below, VIX futures usually trade in contango. In general, the VIX curve only moves into a backwardated shape if the market is under extreme stress and the index itself is at relatively high levels. Of all daily observations since 02/24/2006, the VIX curve was backwardated only 19% of the time, mostly during the financial crisis (2008-2009) or during the depths of the pandemic (March, 2020). Outside of those periods, backwardation (as shown on the left side of the chart and in negative numbers) is relatively rare. 

Source: OptionMetrics

Notable high stress events (measured at the SPX low for each event) in the past show considerable VIX backwardation (as measured by the difference between 180-day and 30-day VIX continuous futures):

Source: OptionMetrics

At the same time, periods of backwardation are usually relatively short, as VIX is a mean-reverting instrument. However, extreme events that only occur once or twice per decade, such as the financial crisis or the pandemic, may produce periods of multi-month backwardation.

The value of the VIX itself also affects the curve. This can be seen by comparing the slope of the futures curve to nearby VIX futures, as charted below:

Source: OptionMetrics

What may we infer from the current shape of the VIX futures curve? 

First, the curve is displaying behavior that usually indicates bearish, or extremely unsettled, conditions. VIX futures were backwardated for 10 trading days between 03/03 and 03/10, reaching 3.45 on March 10th; the last time the market was backwardated greater than 3.00 was on 10/01/2020, during the pandemic. After moving back to contango, the market resumed backwardation on 03/28. This, traditionally, is not the sign of a healthy market.

Second, since backwardation is usually associated with high VIX levels, and the VIX generally moves inversely to the S&P 500, the curve may be indicating more negative equity swings to come.

For more insights on futures, stocks, ETFs, the options market, and volatility, visit the OptionMetrics blog.

There is an inherent risk involved with financial decisions. The information in this article is for informational purposes only and is not intended to provide financial advice. Views expressed are those of the author and are not necessarily those of the company.