Term Structure Trading

Term structure trading focuses on the relationship between implied volatilities at different expiries. Rather than betting that volatility will rise or fall overall, a term structure trader bets that short dated volatility will move relative to long dated volatility: that an inverted curve will normalise, that a steep curve will flatten, or that an event is mispriced in one expiry. The main tools are options calendar spreads and VIX futures spreads.

Shapes and opportunities#

See Volatility Term Structure.

Options calendar trades#

A long calendar sells a near expiry and buys a far expiry at the same strike. It profits from:

• The front volatility falling relative to the back, such as after an event.
• Time decay in the front option, if the underlying stays near the strike.

A reverse calendar (buy front, sell back) profits if front volatility jumps relative to back, for example if a crisis hits. See Calendar Spreads.

Vega weighting#

Short dated implied volatility moves more than long dated. A calendar that is vega neutral in raw terms can still behave like a long or short volatility trade. Traders often weight vega by √(reference time / time to expiry) to compare exposures. See Vega.

VIX futures term structure trades#

VIX futures for different months form a curve. Common trades:

• Short front month VIX futures in contango: profits as futures roll down towards a lower spot VIX. This is the core of short volatility products, and it can lose heavily in spikes.
• Calendar spreads in VIX futures: for example, long the second month and short the first, which can benefit when the front of the curve jumps in a spike (though the opposite is more common in calm markets).
• Long VIX futures as a hedge: expensive to hold in contango because of negative roll yield. See Roll Yield and Contango.

Event term structure trades#

Scheduled events create a hump at the expiry that covers them. Traders can:

• Sell the event expiry and buy the next one if they think the implied event move is too large.
• Buy the event expiry and sell the next one if they think it is too small.

The implied event move can be extracted from the difference in total variance between expiries before and after the event. See Earnings Trading.

Risks#

• Volatility spikes: short front volatility trades can lose very quickly.
• Moves away from the strike: options calendars lose if the underlying moves far.
• Changing regimes: curves can stay inverted or steep for longer than expected.
• Product structure: exchange traded products tied to VIX futures can behave very differently from spot VIX, as February 2018 showed when several short volatility products collapsed in a day.

Managing term structure positions#

1. Weight vega by expiry and stress test spikes in the front.
2. Limit size in short front volatility trades.
3. Use options to cap risk, such as VIX calls as protection for short VIX futures.
4. Track the VIX to VIX3M ratio as a gauge of curve stress.

Frequently asked questions#

What is volatility term structure trading?#

Trading the difference between implied volatilities at different expiries, betting on changes in the curve's slope or on mispriced events.

What is roll yield in VIX futures?#

The gain or loss from futures converging toward spot over time. In contango, long VIX futures lose and short positions gain as futures roll down.

Why are short VIX trades risky?#

Because VIX can spike suddenly, causing losses far larger than the steady gains collected in calm periods.

Next, learn to trade index volatility against single stocks in Dispersion and Correlation Trading.