Implied Volatility Term Structure

SUMMARY

The implied volatility term structure represents the relationship between implied volatility levels and time to expiration for options on the same underlying asset. This fundamental concept in options trading provides crucial insights into market expectations of future volatility and helps traders make informed decisions about option pricing, risk management, and trading strategies.

Understanding implied volatility term structure

The implied volatility term structure shows how the market prices volatility across different expiration dates. It's a key component of options trading and forms the basis for many volatility trading strategies.

When plotted, the term structure typically shows implied volatility levels on the y-axis against time to expiration on the x-axis, creating a curve that reveals market sentiment and expectations.

Common term structure shapes

Contango (normal)

In a normal market environment, implied volatility typically increases with time to expiration, reflecting greater uncertainty about future price movements. This upward-sloping curve is called contango.

Backwardation (inverted)

During periods of market stress or anticipated events, the term structure may become inverted, with shorter-term options showing higher implied volatility than longer-term options. This pattern often indicates immediate market concerns.

Flat

A flat term structure suggests similar volatility expectations across different time horizons, though this is relatively rare in practice.

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