Volatility trading is becoming very popular in the Investment Banks and Hedge Funds’ trading rooms; therefore, I would like to make a brief summary of the tools more frequently used by traders. First, it is essential to point out the difference between historical volatility and implied volatility. On one hand, historical volatility is a backward looking indicator and it represents the realized volatility of a financial instrument over a given time period; on the other hand, implied volatility is the estimated volatility of a security’s price.
The instrument used to measure the implied volatility of the S&P500 Index is the CBOE (Chicago Board Options Exchange) Volatility Index, better known as “VIX Index” or “Fear Index”. As it is possible to see from the chart below, there is a negative correlation between the VIX Index and the S&P500. Therefore, the VIX can give us an idea of the level of panic in the market.
The VIX Index is not an instrument that you can trade directly; however, VIX Futures and Options are easily tradable. In particular, the CBOE makes available nine VIX Futures contracts with different maturity and price.
Therefore, traders can analyze the shape of the VIX Future Term Structure in order to understand the market sentiment.
For example, it is possible to compare the VIX Futures curve before and after the last Fed meeting. As you can see from the graphs below, the VIX Futures Term Structure has changed significantly.
From the first graph, it is possible to notice that the curve has a positive slope; this is the most common situation in the market and it is known as contango. On the other hand, the second graph represents the term structure after the Fed meeting. What it is uncommon is the slope of the curve: short-term future (October) quotes higher than long-term ones (November, December and January). This situation is known as backwardation. The shift in the VIX Futures curve has been caused by the Fed decision to keep interest rates unchanged, which has strongly increased the uncertainty and the volatility in the market. Therefore, as the VIX Futures Term Structure is telling us, investors are more worried about the short than the long run.
To conclude, it is possible to say that the VIX Future Term Structure is a very useful instrument, which can allow us to understand investors’ sentiment and markets dynamics.