A cheap-looking long in volatility-index futures is a classroom, not a fear hedge

What the cash index and its futures are

The cash volatility index is constructed from the implied-volatility component of equity-index option prices. Implied volatility is the share of an equity-index option price that reflects expected future price fluctuation, and it is the input from which the cash volatility index is built. Listed futures on that index, the volatility-index futures, are instruments for expressing a view on expected future equity-market volatility rather than for owning a cash-yielding asset.

In this market, volatility is treated as synonymous with equity selling pressure. That fear-index usage is shorthand for a proxy of equity selling pressure and complacency, not two-way price noise in general. The volatility index generally falls when the equity index rises and rises when the equity index falls.

The volatility index does not pay dividends or interest and does not confer ownership of an underlying store of value. Its level is produced by opinion, emotion, and perception.

Time erosion if equities stall

When equities trade sideways without a selloff, participants typically mark down expected future volatility. The volatility index then tends to lose value as time passes, similar to a long option that is not immediately proven right.

That time erosion leaves a long volatility-index position with less room for delayed timing than a long position in many other markets.

Which listed month is held

The cash volatility index is usually listed below the front-month futures price, and the next futures month is typically priced above the front month. That shape is contango: deferred contract months are priced above nearer months, and nearby futures sit above the cash index.

Contract month selection is the choice between the cash index, the front-month future, and the next expiry. The month that is held determines how much curve premium a long position must overcome as expiration approaches.

Carry that is not a warehouse cost

Unlike agricultural markets, where a rising futures curve often reflects physical cost of carry, the usual premium of deferred volatility-index months over nearby months is attributed to uncertainty in emotions and expectations that fades as time passes.

Commodity carry in physical markets can reflect storage and financing cost. In volatility-index futures the same-looking premium is attributed to fading uncertainty rather than warehousing.

If other conditions are unchanged, a long nearby volatility-index futures position loses as the futures price and the cash index converge. Cash-futures convergence is the process by which those two prices move toward each other as expiry nears, and in a contango curve it works against an unchanged long futures holding.

Low readings still leave downside

The volatility index tends to rise quickly and decline slowly. A reading near historically low levels implies remaining downside that is smaller than potential upside, without eliminating that remaining downside.