Term Structure, SKEW and Tail Risk

Term Structure

Understanding the term structure is essential before implementing option strategies, as it reveals how implied volatility changes across different expiration dates. The volatility term structure is a graph showing the relationship between option expiration and implied volatility, helping you understand how expected volatility varies at different time horizons and affects option prices.

The curve examines options with the same strike price but different expirations, typically focusing on at the money strikes. You can find the term structure in our daily report. The curve has three distinct parts: the front end (also called the short end) with short-term maturities, the mid or belly in the central part, and the back end (also called the long end) with more distant expirations.

The curve takes different shapes based on market sentiment. In contango (normal structure), the front end is lower than the back end because short sellers bring down short-term volatility while the long part rises due to term premium. Markets not under stress price longer expirations higher due to future uncertainties. In backwardation (inverted structure), which occurs during market stress, the short end rises dramatically as investors chase gamma by buying short-term options for protection. These upside moves can be very fast and burn capital quickly if you sell options.

Understanding term structure explains why big ETNs don’t work for long-term investment. These products follow spot prices by buying and selling futures monthly, subjecting them to negative roll in contango markets where expiring contracts are sold low and new ones bought high. The ETN on the VIX demonstrates long-term value erosion despite short-term opportunity. In backwardation, the opposite occurs with positive roll, as seen recently with the USO ETN following oil prices.

This lesson prepares you for the operational section by covering critical volatility concepts. Understanding whether your asset is in contango or backwardation helps you assess volatility regimes and manage risk, particularly for time spread trades where term structure becomes especially important.

Video Chapters

  1. 00:00 – Introduction to term structure definition
  2. 01:02 – Parts of the curve: front end, belly, and back end
  3. 01:38 – Contango and normal market structure
  4. 02:14 – Backwardation and inverted structure during stress
  5. 03:25 – Why big ETNs don’t work long-term
  6. 04:42 – Negative roll and positive roll explained

Key Takeaways

  1. The volatility term structure shows how implied volatility changes across different expirations for the same strike price
  2. Contango represents normal markets with lower front-end volatility, while backwardation signals market stress with elevated short-term volatility
  3. Understanding term structure explains why ETNs suffer from negative roll in contango markets, eroding long-term value
  4. The curve’s shape is critical for trading time spreads and managing risk when selling options
Video Transcription

[00:00:00.07] - Speaker 1
We have covered a lot so far and we are preparing for the operational section. But before it is necessary to cover other important points before you can be able to put on an option strategy. In this lesson we will talk about the term structure. Let's start with the definition. The volatility term structure is a graph that represents the relationship between an option expiration and its implied volatility.

[00:00:20.17] - Speaker 1
In other words, it shows how the expected volatility of a stock or index varies at different time horizons. This relationship is important because it helps us understand how expected volatility changes over time and how it affects the prices of options. The term structure represents the volatility of an option. More specifically, we are looking at options that have the same strike price but different expirations. This curve becomes particularly important for those who then trade time spreads.

[00:00:45.06] - Speaker 1
This is the classic chart of the term structure. On the left you have the volatility and on the right you have the expirations. Usually when we look at term structure, we look at the at the money term structure. So we are looking at the at the money strikes for different expiries across the term structure. You can find the term structure in our daily report as well.

[00:01:02.19] - Speaker 1
When we look at the curve, it is important to distinguish between its different parts. This is important because often when investors talk about volatility, they are talking about the volatility in different parts of the curve. The short part of the curve is known as the front end. It is also sometimes called the short end. In this part of the curve, you will find the short term maturities.

[00:01:20.22] - Speaker 1
As we move along, we arrive at the mid of the curve. This is the central part, sometimes also known as the belly. You then arrive at the back end, also known as the long hand of the curve. Here instead, we find the more distant expirations. Now the curve can have different shapes based on the sentiment and positioning of the participants.

[00:01:38.15] - Speaker 1
In this slide, we see the curve in contango. This can be defined as a normal structure. In this case, the front end of the curve tends to be lower than the back end of the curve. But why does this happen? Because there are enough short sellers in the market that gain by selling volatility.

[00:01:52.28] - Speaker 1
This brings down the volatility in the short end of the curve. The long part, on the other hand, is on the rise thanks to the term premium. In a nutshell, in this type of structure, the market which is not currently under stress, foresees possible volatility in the future. This is why longer expirations are priced higher. In the previous section, we talked about the importance of uncertainty in options valuation.

[00:02:14.02] - Speaker 1
Also, in this case, the term premium or volatility premium is due to the fact that in the future there are more uncertainties with respect to events that could lead to an increase in volatility. For these reasons, investors pay a premium to belong on that part of the curve. Then we have the backwardation, also known as the inverted structure. This is the market structure that we find when there is stress in the market. In 2020, for example, we saw a stock market crash with a short VIX curve rising.

[00:02:40.08] - Speaker 1
But why does this happen? Because when there is stress and volatility, investors look for protection. When they seek coverage, two things can happen. They chase the gamma by going long options and they pay the premium that brings up the volatility. Furthermore, investors tend to buy short term options in these events, which is why the curve takes this shape.

[00:02:58.08] - Speaker 1
These upside moves on the short end tends to be very fast. It is for this reason that it is very important to understand the volatility regime of your asset if you sell options. Because this type of increase in the curve can burn your entire capital in a very short amount of time. In this slide, we can see how the market structure moves when it goes from a contango structure or normal structure to a backwardation structure or inverted. In this case, the stock market goes down while the volatility term structure reverses and goes into backwardation.

[00:03:25.14] - Speaker 1
The volatility of the expirations in the short end rises faster than the ones in the long end in this slide. Instead we see how the market normalizes in in this case, the stock market goes up while the volatility structure goes back to contango. Volatility on the short end falls faster than the one on the long end of the curve. At this point, we want to cover a topic that many of our users often why don't big CTN work? Understanding the term structure also helps us understand why this type of product cannot be used for long term investment.

[00:03:54.18] - Speaker 1
To invest in an index or a commodity such as oil, for example, it is done through futures. However, investing in futures is dangerous and many retailers do not want to take on the risk given the financial leverage. For this reason, ETFs and ETNs have been created over time that follow the spot price of a commodity or index such as the VIX in this case. But they do this by buying and selling futures each month. They have to roll out expiring positions with new contracts at later expirations.

[00:04:20.07] - Speaker 1
Therefore, the ATN is subject the exposure to the curve or term structure. Its performance depends on the structure of contango or backwardation. Futures as options have an expiration and to remain in the position, the fund manager of the ETN must be selling expiring contracts and buying new ones. The price at which the manager rolls the position depends on the term structure. Let's see this in the next slide.

[00:04:42.15] - Speaker 1
The market, as we said, is generally incontanguable. This means that the short part of the curve is lower than the far one. For this reason, the cost of contracts further away is higher. In this case, a product that prices according to this term structure suffers from what is called negative roll. But what does rolling mean?

[00:04:59.05] - Speaker 1
Rolling means selling the expiring contract and buying a new one with a further expiration. The sold contract has a lower value than the contract we buy to stay in the position for this reason. If we stay in this position for the long term, the value of our investment will continue to decrease every time we have to roll. Here we can see an example of the ETN on the vix. In the short term we can take advantage of the movements, but in the long term the product tends to lose precisely because of the negative roll.

[00:05:25.00] - Speaker 1
The cost of rolling affects the performance of the etf. When we are in backwardation, the opposite happens and the roll is positive for our position. Volatility is highest at the front of the curve. The cost of the closest contract is higher. For this reason, the contract we sell has a higher value than the one we buy to stay in the position.

[00:05:42.04] - Speaker 1
Let's look at an example and use the USO ETN which follows the price of oil. USO has suffered from negative roles in the past. As the price of oil was in contango. Recently, the curve has reversed and USO has benefited from the positive role and the structure of backwardation. We are coming to an end to the lesson about term structure.

[00:06:00.25] - Speaker 1
In the next section we will look at the skew.