Volatility Metric - M1:VIX roll yield - How do volatility ETPs work?

VTS Community,

Today I'm going to introduce the next metric in the VTS Volatility Dashboard, available to all subscribers in every morning blog. It's an important metric to understand as a building block because it is getting more specific to how the volatility ETPs actually derive their price.

M1:VIX roll yield

In the volatility space we often throw around terms like contango, backwardation, M1:M2 VIX futures, M4-M7 VIX futures, etc. These are all terms that relate to the shape of the VIX futures term structure. It's definitely important and is a decent indication of current volatility levels, but that's not actually the mechanism that volatility ETPs like VXX, UVXY, SVXY, VIXY derive their price. It's a common misconception that the vol ETPs derive price based on buying and selling more or less expensive futures, and that it's the buy high sell low, or buy low sell high cycle that values them. That's not actually what's happening. For the true pricing mechanism, we have to introduce a new term:

Convergence

More specifically, convergence to the spot VIX price. The pricing mechanism actually has to do with the fact that VIX futures are constantly moving down the curve and expiring. Day after day, month after month, VIX futures are moving down the curve towards the spot VIX price, where ever that may be at the time. Here is a fully labelled VIX futures term structure as our baseline.

VIX futures term structure on Apr 26, 2019:

 

The way this works is, every day the VIX futures move down the curve to the left towards expiration. On the third Wednesday of every month the front month M1 VIX future expires. When that happens, M1 disappears. The old M2 becomes the new M1. The old M3 becomes the new M2, M4 becomes M3, etc. All the futures move down the curve.

* I made a video you can check out discussing this VIX futures monthly expiration cycle

On the final day right before expiration, M1 converges to the spot VIX index price and they are one and the same. For only that moment right before expiration, M1=VIX. This is why we call it convergence to the spot VIX. Because everyday that goes by, those VIX futures are moving down the curve and converging to the spot VIX.

So if volatility ETPs such as VXX, UVXY, SVXY, VIXY are holding a composition of M1 and M2 VIX futures and they derive their price based on the value of those futures, it is quite important to know which direction the VIX futures are converging. Is it up or down?

Referring to our baseline chart from above, as of Apr 26, 2019 the VIX futures are converging down towards the spot VIX which is below the front month future M1. Currently there is a positive M1:VIX roll yield.

Apr 26, 2019:

 

We can also take a look at an example of a period where the VIX futures would be converging upward towards the spot VIX. Remember Q4 2018? It was an ugly one for the stock market. Let's check out the term structure at the lows on Christmas eve. This was an example of a time with negative M1:VIX roll yield.

Dec 24, 2018:

 

On Dec 24, 2018 the spot VIX index was all the way up at 36.07, but the front month VIX future M1 was at 25.90, and all the other futures were below that. This means the "roll yield" is actually negative, and the VIX futures may be pulled upwards towards the spot VIX.

What does M1:VIX tell us?

Since we know that at expiration M1 = VIX, this "roll yield" difference between the front month future and the VIX will be closed by expiration. Depending on which side of the VIX index the VIX futures are trading, it may be an indication which direction the futures are likely heading.

* Now of course this is all dependent on the trend continuing. All metrics by themselves are just snapshots in time and not predictive. Markets behave differently in different environments and they can change quickly. A trader needs a comprehensive understanding of all the different aspects of the volatility space to be successful. M1:VIX roll yield is only one of many. However, if the trend continues we can generalize a few basic rules:

- When M1 > VIX, this is positive roll yield and the futures are converging down. All other things being equal, a continuation of trend may be a tailwind for short volatility products (SVXY) and a headwind for long volatility products (VXX, UVXY, VIXY)

- When M1 < VIX, this is negative roll yield and the futures are converging up. All other things being equal, a continuation of trend may be a headwind for short volatility products (SVXY) and a tailwind for long volatility products (VXX, UVXY, VIXY)

Contango and backwardation in the VIX futures only matter in relation to where the spot VIX is and how the futures are converging towards expiry. So keep an eye on the M1:VIX roll yield, how strong it is, and that will be useful in determining what side of the volatility trade has the higher probability of success.

Here are a few real examples where we can actually see the VIX futures curve converging towards spot VIX over a period.

Positive roll yield, converging down: Mar 29 - Apr 15, 2019

 

Negative roll yield, converging up: Nov 27 - Dec 17, 2018

 

Spoiler alert! Remember my two articles M1:M2 VIX futures and adjusted M1:M2 VIX futures? The second was a follow up to the first showing how to make the necessary adjustments. Just like with those, we also have to adjust the M1:VIX roll yield. My next article will be explaining how we adjust M1 into what's called VX30, or the 30-day constant maturity VIX future. The plot thickens.....