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The volatility term structure is the relationship between implied volatility and time to expiration. The term structure is important because it provides information about the market’s expectations for future volatility. For example, if the term structure is downward sloping, it means that the market is expecting implied volatility to decrease in the future. This is called a backwardation term structure. Conversely, if the term structure is upward sloping, it means that the market is expecting implied volatility to increase in the future. This is called a contango term structure.
The state of the volatility term structure can be used to generate trading signals. For example, if the term structure is in backwardation, it may be a good time to go long volatility and vice versa. This can be done through buying and selling volatility Exchange Traded Notes.
Reference [1] formally tested trading strategies based on the VIX term structure,
The purpose with this paper is to investigate if the dynamics of VIX term structure can be exploited for trading strategies in order to yield abnormal returns. To do this, three different strategies was created based on signals indicating if the VIX spot price and the VIX future front month price is in contango or backwardation. The strategies were assumed to trade VIX and S&P 500 ETFs, a choice based on earlier literature findings that investigates the price discovery of VIX ETPs and documenting that such products performs according to the underlying derivative well. The strategies were thereupon tested on a set of historic data during the sample period of October 2011 to March 2020. The results could provide an answer for the research question, and based on empirical evidence, it can be concluded that the strategies generate abnormal returns.
In short, trading strategies based on the VIX term structure can deliver alpha.
Of the strategies tested, we found LSLV particularly interesting. It has a high Sharpe ratio with a low drawdown. We note, however, that the equity market was in the bull market during the tested period.
References
[1] Henrik Mark-Almqvist and Oskar Fransson, Trading strategies based on the VIX term Structure, 2020, Umeå University
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