Understanding the Key Factors Influencing VIX

Election-Time Market Turbulence

With India in the midst of its General Elections, the stock markets are anything but steady. This rollercoaster ride is leaving investors feeling jittery, driving them to scrutinize every possible market indicator for a clue about when the storm might pass. One such indicator that recently grabbed their attention is the India VIX. But what does it really tell us about market volatility?

India VIX’s Plunge: What Does It Mean?

Recently in April, the India VIX fell from 12.7 to 10.1—a drop of nearly 20% in a single session. To many, this steep decline suggested that the market was starting to settle down, indicating that the uncertainty surrounding the General Elections might be fading. This line of thinking was bolstered by the fact that similar drops in the VIX occurred on May 23, 2019, and May 16, 2014, when election results favored the incumbent NDA party. Given this context, it seemed plausible that the 20% dip signaled a return to market stability.

But is this assumption correct? Does a sudden drop in the India VIX really indicate that election-related uncertainty is behind us? To answer these questions, it’s crucial to understand what the India VIX measures and what its limitations are.

Decoding the India VIX

The India VIX, or India Volatility Index, is designed to gauge the expected volatility in the Nifty50 over the next 30 days. It does this by looking at the forward value of the Nifty in its futures contracts and examining the expected variance through the lens of out-of-the-money options contracts for the current and following months. In simple terms, the VIX uses data from options traders to predict how much the Nifty50 might fluctuate over the coming month.

However, this approach has its limitations. First, it only reflects volatility in the Nifty50, ignoring broader market movements, particularly in small- and mid-cap stocks. This means that while the VIX might suggest a calming market, other sectors could still be experiencing high levels of volatility.

Moreover, the VIX’s focus on the Nifty50 means it might not accurately capture the full range of market sentiment, especially during major events like the General Elections. This points to the risk of overinterpreting a single indicator, as market movements can be driven by a variety of factors, not just election outcomes.

Two, the VIX (Volatility Index) is influenced by the volume of trades and the patterns of buying or selling in the options contracts that it relies on. This can lead to fluctuations in the index. For example, the drop in the VIX on April 23, 2023, was attributed to traders reducing their positions in Nifty options ahead of the April 25 contract expiry and the impending elections. Additionally, the VIX shifts its focus from the current month to the following month three days before monthly expiry, which might have contributed to the movement.

Three, and most importantly, globally, volatility indices like the VIX are considered reliable predictors of market trends because derivative markets are typically managed by seasoned investors. Ideally, options are bought and sold by institutional investors and portfolio managers who use them to hedge risk or make directional market predictions. However, in India, the options market is predominantly driven by retail investors looking for quick profits. Many retail investors favor out-of-the-money options because they’re more affordable. This raises questions about whether these retail investors are making informed decisions or simply gambling. Consequently, the India VIX’s ability to predict market trends is compromised.

Why India VIX Isn’t Perfect

When it comes to what the VIX reveals, historical data suggests it hasn’t been particularly effective at predicting market turbulence. For instance, during the initial phase of the Covid-19 pandemic, the Nifty index plummeted by 38%, from 12,201 on February 12, 2020, to 7,610 on March 23, 2020. The India VIX didn’t show any significant signs of impending volatility prior to this drop. It ranged between 14 and 17 from January 1 to February 19, 2020, before rising to 25 by March 3, well after the market correction had begun. The VIX continued to climb, reaching levels between 60 and 70, and eventually peaking at 83 a day after the Nifty50 bottomed out. Even though the market began to recover by July 2020, the VIX stayed elevated and didn’t fall below 15 until June 2021.

Similarly, the VIX didn’t predict the 2008 market crash during the global financial crisis. In fact, the index decreased from about 40 in November 2007 to 28 by January 8, 2008, right when the Nifty50 started its 60% drop from its peak.

The VIX has also failed to indicate positive market triggers. Before the Indian general election results were announced on May 23, 2019, the VIX stayed at high levels (21-29), suggesting investor anxiety. After the election results, which favored the ruling party, the index dropped to 15-16, indicating calm.

Conclusion

All of this suggests that you can’t rely on the India VIX to predict future market trends or significant events. However, it can be useful for gauging the current sentiment in the market. In retrospect, high levels on the VIX, reaching 70-80, often indicated market bottoms and were good buying opportunities. Levels above 80 were extreme and generally aligned with the market hitting rock bottom. On the other hand, readings below 20 suggest a relaxed market, while the recent reading of 10 indicates possible complacency and overconfidence. This means that even a slightly unfavorable election result could trigger a significant market correction due to high expectations.

Disclaimer: This blog has been written exclusively for educational purposes. The securities mentioned are only examples and not recommendations. It is based on several secondary sources on the internet and is subject to changes. Please consult an expert before making related decisions.