volatility - Why is the VIX futures market usually in a state of contango?

I'm a VIX newbie and I'm trying to understand why the VIX futures market is usually in a state of contango.

All I can figure is that the sellers of VIX futures contracts demand high "prices" (because the seller is the holder of the short position and makes money when the price falls), and since there are willing buyers, namely ETNs and ETFs that are trying to track the S&P 500 VIX SHORT-TERM FUTURES INDEX (SPVIXSTR) through the purchase and sale of VIX futures, the contracts get sold.

Also, the farther out the futures contract expires, the less certain the seller is about what the value of the VIX and the SPVIXSTR will be at the future's expiration date. The greater uncertainty over a longer term results in the seller demanding higher premiums over a longer term than he would demand over a shorter term.

It seems like a prudent buyer of VIX futures wouldn't buy contracts that are priced so high.

It seems like the VIX futures market should be in a state of contango about as frequently as it is in a state of backwardation.

What causes contango in the VIX futures market, and why is it the usual state of the market?

Answer

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  Your questions about contango in VIX futures have close analogies in options too. The Black & Scholes model suggests that all time frames and all strikes should have the same implied volatility, but they don't. I think one of the reasons is that the B&S model assumes that stock returns are distributed in a normal (gaussian) distribution, but the actual returns don't match a gaussian distribution all that well. For example the actual occurrence of big crashes / gains is much more likely than a normal distribution would predict. Since crashes do occur people are willing to pay what the B&S considers a premium to have some insurance against downswings. I view it as being an insurance cost, so the longer youwant the insurance for, the more it will cost you. If you look at the term structure of SPX options you'll see a term structure that looks a lot like the VIX futures curve. The VIX futures on settlement will use the SPX options expiring one month later as the prices for settlement (e.g., Nov VIX futures will settle to Dec SPX options).

  
  


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  The VIX futures tend to go no higher than around 9% above their equivalent SPX option VIX style implied volatility value , so I suspect above that some sort of arbitrage gets attractive, and the price difference is limited.

  
  
  


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  One other thought about VIX futures. They are attractive because you don't have to place your bets as specifically as you do if you are buying out of the money puts for insurance against crashes. If you buy puts and the market rallies your puts are left very out of the money, whereas the VIX can spike up regardless of where the value of the SPX index is. Clearly people are willing to pay a premium for VIX futures, and I don't think they are stupid. At lot of them lived through the 2000 and 2008 bear markets--that leaves an impression on you.