The volatility term structure
A stock does not have one implied volatility but one for every expiry. Plot the at-the-money IV of each against its days to expiry and you have the term structure: the market's view of how volatile the stock will be over each stretch of the future.
The normal shape: contango
Most of the time the curve slopes gently upward: later expiries carry a little more IV than near ones. Over a longer horizon more can go wrong, and sellers of long-dated options ask to be paid for it. This calm, upward shape is called contango, borrowing the futures market's word.
The inverted shape: backwardation
When near expiries carry more IV than later ones, the curve is inverted, in backwardation. Two things cause it:
- An event close by. An earnings report, a court ruling, or a drug decision sits inside the near expiries and not, in proportion, in the far ones. The inversion is local: a kink at the first expiry after the date (see the IV crush).
- Stress now. In a sell-off the market pays most for protection over the next weeks, and the whole front of the curve lifts above the back. For an index this is one of the clearest signs of fear; it tends to ease as the stress passes, and the curve returns to contango.
Forward volatility
Two points of the curve also price the stretch between them. Implied variance (IV squared) adds up over time, so the IV the market implies between two expiries, the forward volatility, is:
forward σ = √((σ₂² × T₂ − σ₁² × T₁) ÷ (T₂ − T₁))
with σ₁ and σ₂ the IVs of the expiries T₁ and T₂ years away. An example: a 30-day IV of 40% and a 60-day IV of 35% give a forward volatility of √((0.35² × 60 − 0.40² × 30) ÷ 30) ≈ 29% for the second month. A forward that spikes between two expiries isolates an event there: the jump in variance across an earnings date is that report's priced move.
The IV surface
Put the term structure together with the skew and you have the IV surface: implied volatility by strike along one axis and by expiry along the other. Its rows show how the skew changes with time, short-dated smiles usually being steeper; its columns show the term structure at each strike. A cell much richer or cheaper than its neighbors may mark an event, a crowded trade, or a stale quote, so check the bid and ask before trusting it.
Trading the curve
Calendar spreads sell a near expiry and buy a later one at the same strike. They are bets on the shape of the curve: cheap to put on when it is steep in contango, and hurt when the front spikes over the back. An inverted curve with no event to explain it is the classic case for a calendar, on the view that near-term stress eases faster than longer-term worry.
In Options Meerkat
On a symbol's detail page the term structure view (e) draws the at-the-money IV of every expiry with the forward volatilities between them, and the IV surface (V) colors IV by strike and expiry, green where it is cheap and red where it is rich. The opportunity scan (O on the list) flags an inverted term setup when the 30-day at-the-money IV is at least 1.08 times the 90-day one with no earnings report to explain it.