Most options traders focus on a single expiration date, but sophisticated traders know that comparing volatility across different expirations reveals powerful trading opportunities. This is term structure trading, and it can give you an edge that few retail traders understand.
What is Volatility Term Structure?
Volatility term structure is the pattern of implied volatility across different expiration dates. Just as strike prices have different IVs (skew), expirations have different IVs too. When you plot IV against time to expiration, you get the term structure curve.
Think of it like interest rates: Just as short-term and long-term interest rates differ, short-term and long-term implied volatility differ. This difference creates trading opportunities.
Contango vs Backwardation
The two main shapes of the term structure are contango and backwardation:
Contango (Normal Term Structure)
Far-dated options have higher IV than near-dated options. This is the "normal" state because:
- More time means more uncertainty
- More events could happen over longer periods
- Sellers demand more premium for longer commitments
Contango Example
Stock XYZ term structure in a calm market:
- 7-day expiration: 22% IV
- 30-day expiration: 25% IV
- 60-day expiration: 27% IV
- 90-day expiration: 28% IV
IV increases as you go further out in time - this is contango.
Backwardation (Inverted Term Structure)
Near-dated options have higher IV than far-dated options. This happens when:
- There is immediate uncertainty (earnings, FDA, etc.)
- A market crash is happening or expected
- Extreme fear is priced into short-term options
Backwardation Example
Stock XYZ term structure before earnings:
- 7-day expiration (includes earnings): 55% IV
- 30-day expiration: 35% IV
- 60-day expiration: 30% IV
- 90-day expiration: 28% IV
IV is highest for the near-term expiration that includes the event.
Why Term Structure Matters
Understanding term structure helps you in several ways:
- Find relatively cheap/expensive options: Compare IV across expirations to find the best value
- Predict volatility direction: Steep contango often precedes volatility increases
- Structure better trades: Calendar spreads exploit term structure differences
- Understand market expectations: Term structure reveals what events the market is pricing
Trading Strategies Based on Term Structure
Strategy 1: Calendar Spreads
The classic term structure trade. Sell short-term options and buy longer-term options at the same strike.
Calendar Spread in Contango
Stock at $100, contango term structure:
- Sell 30-day $100 call at 25% IV for $3.00
- Buy 60-day $100 call at 28% IV for $4.50
- Net debit: $1.50
You profit if the stock stays near $100 as the short-term option decays faster than the long-term option.
Strategy 2: Diagonal Spreads
Similar to calendars but with different strikes. This combines term structure with directional bias.
Strategy 3: Double Calendars
Set up calendars at two different strikes (one below, one above the current price) to profit from range-bound movement.
Strategy 4: Front-Month vs Back-Month Ratio
In steep contango, sell multiple front-month options against fewer back-month options to capture the IV differential.
Trading Term Structure Around Events
Events create temporary distortions in term structure that can be traded:
Before Earnings
- Term structure inverts (backwardation) for expirations including the event
- Sell calendars (short back-month, long front-month) if you think event IV is overpriced
- Buy calendars if you want long exposure that survives the event
After Earnings
- Term structure normalizes (returns to contango)
- Front-month IV crushes rapidly
- Calendar spreads that were long the back-month benefit
Pro tip: If you buy a calendar spread before earnings (long the post-earnings expiration, short the pre-earnings expiration), you can profit from the volatility crush in the front-month while maintaining your longer-dated position.
VIX Term Structure as a Market Indicator
The VIX futures term structure is one of the best market indicators available:
- Steep contango (VIX futures higher than spot VIX): Market is calm, expecting normal conditions
- Flat term structure: Uncertainty is building
- Backwardation (VIX futures lower than spot VIX): Fear is high, often near market bottoms
VIX Term Structure Signal
When VIX spikes and the term structure inverts (backwardation), it often signals peak fear. Historically, buying stocks when VIX is in backwardation has been profitable over the following months. But be careful - markets can stay panicked longer than you expect.
Practical Tips for Term Structure Trading
- Check term structure before every trade: Make sure you are buying cheap expirations and selling expensive ones
- Watch for event distortions: Earnings, dividends, and other events create predictable term structure changes
- Use calendar spreads wisely: They work best when term structure is steep
- Monitor VIX term structure: It gives clues about overall market sentiment
- Be patient: Term structure trades often need time to work out
Common Term Structure Mistakes
- Ignoring events: An expiration with an included event will have elevated IV for good reason
- Fighting backwardation: In panic markets, backwardation can persist and deepen
- Oversizing calendars: These are nuanced trades with complex risk profiles
- Forgetting about dividends: Ex-dividend dates affect term structure for dividend stocks
- Not adjusting calendars: As the stock moves, calendar spreads need management
Building a Term Structure Trading Process
- Map the current term structure: Note IV for all available expirations
- Identify the shape: Is it contango, backwardation, or kinked (event distortion)?
- Compare to history: Is the current shape normal or extreme?
- Check for events: What earnings, dividends, or other events explain the shape?
- Select strategy: Match your strategy to the term structure and your market view
- Size appropriately: Term structure trades are typically smaller position sizes
Track Term Structure Across Your Watchlist
Pro Trader Dashboard displays IV term structure for every stock, helping you identify calendar spread opportunities and understand market expectations. See which expirations are cheap and which are expensive.
Summary
Volatility term structure shows how IV differs across expiration dates. Contango (upward sloping) is normal, while backwardation (downward sloping) signals fear or events. Calendar spreads are the primary way to trade term structure, profiting from the differential between front-month and back-month volatility. Always check for events that explain term structure shapes, and use VIX term structure as a broader market indicator. Master these concepts and you will have insights that most traders overlook.
Continue your volatility education with our guide on IV Rank and IV Percentile or learn about volatility crush trading.