The VIX Futures Basis: Evidence and Trading Strategies

Abstract

The VIX index, based on the volatility implied by options on the S&P 500 index, is one of the most watched market indicators. Futures and options written on the VIX are among the most actively traded derivative contracts. But the VIX is quite different from other derivatives underliers. One can’t buy and hold implied volatility, so the cost-of-carry model followed by nearly all futures contracts on financial instruments and storable commodities does not work for the VIX. For nonstorable underlyings, the futures price is not constrained by arbitrage against the cash market and is mostly determined by the market’s forecast of the spot price at futures maturity. If the VIX futures price is the market’s expectation about implied volatility at contract maturity, the futures basis may contain information about which way the VIX is going to move next to close the gap. On the other hand, if VIX futures prices contain a volatility risk premium, the future should lie above the spot VIX on average and is expected to converge toward the spot VIX over time, rather than the reverse. This risk premium can be captured on average by shorting the nearby VIX contract, but the position is exposed to risk that VIX may spike upward if the stock market falls sharply. This risk can be partly hedged using long contracts in the S&P index future. The authors examine these issues and find, as previous researchers have, that the VIX futures basis does not predict the change in the VIX. However, a hedged trade to capture the volatility risk premium can be highly profitable.