Volatility term structure: contango and backwardation

The volatility term structure plots implied volatility, or volatility futures prices, against maturity. When longer maturities trade above shorter ones, the curve is in contango. When the front trades above the back, it is in backwardation. The shape is one of the fastest readings of market stress.

How it works

In calm markets, short-dated volatility sits low and longer maturities carry a premium for uncertainty over a longer horizon, so contango is the usual state. In a sell-off, near-term volatility jumps far more than long-term volatility and the curve inverts into backwardation. On VIX or VSTOXX futures, the shape drives carry. Each future converges to the spot index at expiry: in contango, a long future rolls down toward a lower spot if nothing changes, while in backwardation it rolls up.

Example

Hypothetical: spot VIX is at 15, the front-month future at 17 and the second month at 18.50. If spot VIX is still at 15 when the front contract expires, that future settles near 15, a loss of 2 points, or $2,000 per contract at $1,000 per point. In a stressed market with spot at 35, the front at 30 and the second month at 27, the same mechanics work in the other direction.

On the desk

Traders watch the spread between the first two futures, and the ratio of spot to front month, as stress gauges. The classic mistake is to hold long volatility futures as a hedge without budgeting the roll cost of a contango curve.