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VX Mean Reversion

From Theory To Practice

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As we know, the VX futures curve is usually in a state of contango, where futures prices rise, as you go further out in time. Furthermore, we know that volatility and market prices generally have an inverse relationship. As a result, the VX futures curve can be thought of as an insurance market, where the cost of insurance against a market drop should increase as the time to expiration on the contract also increases.

As a result, given the fact that the market drifts positively over time, we can reasonably conclude from the inverse relationship between volatility and market prices that VX futures will price in future volatility expansion from that current state of contraction. Interestingly, this relationship can be used as support for the idea of volatility mean reversion. While the VX futures is usually in contango, it is not always in contango, and there is no requirement in the markets that forces the curve into contango. Instead, after a huge market selloff like we’ve recently had, if volatility does indeed mean revert, then we would expect to see a VX curve that is in a state of backwardation. In other words, a futures market that predicts falling volatility prices over time, as opposed to the rising volatility prices over time we typically see with contango.

Looking at the VX curve today, we do indeed see clear evidence of this backwardation. Thus, we have even more support for volatility as a mean reverting entity.

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