In the past you could invest in mid-term volatility, four to seven months out, without worrying too much about the erosive effects of contango.  That’s not the case anymore.   Strategies that hold long/short positions in mid-term and short term VIX futures as well as ETPs that hold mid-termVIX futures such as Barclays’ VXZ and XVZ and ProShare’s VIXM are getting dragged down.

Most of the attention in the volatility scene is focused on the 30 day VIX index and the short term VIX futures—the two futures months next in line to expire.  Usually the longer term months are ignored, or used for hedging short-term positions against big volatility spikes.   Historically unless the market is panicky the mid-term months tend to be in slight contango.

The chart below from VIX Central shows a typical term structure of VIX futures prices versus time when the VIX was around 16

VIX Futures term structure 18-Mar-2010

Things have changed.   The August 8^th, 2012 term structure, with the VIX at 15.3 looks like this:

VIX Futures Term Structure 8-Aug-2012

Comparing the two curves in the chart below we see that the 4^th and 5^th months are similar, but now the slope of the mid-term months is much steeper:

VIX future term structure 2010 vs 2012

The mid-term slope in 2010 was 0.125 points per month, the 2012 number is 0.9 pts per month—seven times higher.

Contango on short term futures has been elevated since the 2008/2009, but the average levels have not peaked above the 2009 levels.   The chart below shows short term contango expressed in the percentage monthly erosion you would expect if you held a short term position.

Short Term VIX Future Contango 2004 to Present

Mid-term contango, on the other hand ramped up in 2010/2011 and peak levels have jumped an additional 50% this year.

Medium Term VIX Futures Contango 2004 to Present

A look at the CBOE’s VIX term structure chart below reveals that this steep term structure is also present in the VIX Index.

CBOE VIX Index Term Structure

Since the VIX index just reflects implied volatility on SPX options, the shift in term structures must be present in SPX options also.

Since the SPX option market is considerably bigger than the VIX futures market I assume that the VIX futures are just tagging along—for reference the notional value of the 4^th through 7^th months of VIX futures is currently around $2.5 billion.

Historically mid-term volatility futures are in contango 75% of the time; a sustained increase in average contango from less than 2% per month up into the 3% to 4% range will unhinge a lot of hedging strategies.  Not many schemes can survive that much extra loss.

If you are long medium-term volatility directly, or via an ETP you should reevaluate.

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• The Cost of Contango—It’s not the Daily Roll
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