Vix Futures Term Structure Video

"SKEW AND TERM STRUCTURE TRADING

We examine how skew and term structure are linked and the effect on volatility surfaces

of the square root of time rule. The correct way to measure skew and smile is examined,

and we show how skew trades only breakeven when there is a static local volatility

surface.

 Skew and term structure are linked. When there is an equity market decline, there is

normally a larger increase in ATM implied volatility at the near end of volatility surfaces

than the far end. Assuming sticky strike, this causes near-dated skew to be larger than far dated

skew. The greater the term structure change for a given change in spot, the higher

skew is. Skew is also positively correlated to term structure (this relationship can break

down in panicked markets). For an index, skew (and potentially term structure) is also

lifted by the implied correlation surface. Diverse indices tend to have higher skew for this

reason, as the ATM correlation is lower (and low strike correlation tends to 100% for all

indices).

 Square root of time rule can compare different term structures and skews. When

implied volatility changes, typically the change in ATM volatility multiplied by the square

root of time is constant. This means that different (T2-T1) term structures can be compared

when multiplied by √(T 2T1)/(√T2-√T1), as this normalizes against 1Y-3M term structure.

Skew weighted by the square root of time should also be constant. Looking at the different

term structures and skews, when normalized by the appropriate weighting, can allow us to

identify calendar and skew trades in addition to highlighting which strike and expiry is the

most attractive to buy (or sell).

 How to measure skew and smile. The implied volatilities for options of the same

maturity, but of different strike, are different from each other for two reasons. Firstly, there

is skew, which causes low-strike implieds to be greater than high-strike implieds due to the

increased leverage and risk of bankruptcy. Secondly, there is smile (or convexity/kurtosis),

when OTM options have a higher implied than ATM options. Together, skew and smile

create the ‘smirk’ of volatility surfaces. We look at how skew and smile change by

maturity in order to explain the shape of volatility surfaces both intuitively and

mathematically. We also examine which measures of skew are best and why.

 Skew trading. The profitability of skew trades is determined by the dynamics of a

volatility surface. We examine sticky delta (or ‘moneyness’), sticky strike, sticky local

volatility and jumpy volatility regimes. Long skew suffers a loss in both a sticky delta and

sticky strike regimes due to the carry cost of skew. Long skew is only profitable with

jumpy volatility. We also show how the best strikes for skew trading can be chosen." -

Santander

Global Banking & Markets

C.B. & M.A.G