Investors investing in the money market are aware of market volatility and know it can impact their returns. To understand the extent of market volatility on their investment, investors need to quantify volatility to base their decisions. But how do you measure volatility in the market? A volatility index comes into the picture here. It is an index to benchmark market volatility against it to measure changes in volatility factors. In Indian bourses, India VIX is a volatility index that functions as a market barometer.
What is market volatility?
For the uninitiated, volatility refers to periods of unpredictability when security prices go through rapid fluctuations. Often people associate volatility with price falls. But it can also happen in an uptrend.
What causes volatility? Several factors can contribute to market movement, as enumerated below.
- Political and economic factors
- Industry and sector performance
- Company performance
Volatility is normal in the long run as stock prices go through periods of uptrends and downtrends depending on external and internal factors. These phases are unsettling but unavoidable.
India VIX index meaning
India VIX refers to the India Volatility index. It measures the amount of volatility that traders expect over the next thirty days in the NSE index. Simply, it is a calculation of price swings investors expect in the market over important market news. When the value of the index is low, it indicates the absence of fear factor in the market, meaning investors are more confident to invest. Conversely, a higher value is an indication of rising uncertainties and fear factors.
Although India VIX was introduced in the market in 2008, the volatility index originally appeared in the Chicago exchange in 1993. It helped gauge the presence of fear factors in the market.
What is India VIX in the stock market?
India VIX is the moniker used for the volatility index in NSE. It considers five variables for calculation – strike price, the market price of the stock, expiry date, risk-free returns, and volatility. VIX measures volatility expected by investors by taking into account the best bid and ask quotes of the out of the money, present, and near-month NIFTY options contracts.
VIX and volatility move in the opposite direction. A higher VIX indicates higher volatility in the market, vis-a-vis a lower VIX, which means low volatility in NIFTY.
Let’s understand with an example.
Suppose, VIX value is 15. It means investors expect prices to fluctuate in the range of +15 and -15 in the next thirty days. Theoretically, VIX oscillates between 15 and 35. Any value around or below 15 represents low volatility against values higher than 35, which indicate high fluctuations in the market. In the past, NIFTY and VIX had shared a negative relationship, meaning NIFTY rose each time VIX was below 15.
India VIX in the stock market represents whether investors are feeling fearful or complacent in the short term, an indication of market choppiness.
How is India VIX Calculated
The India VIX figure is derived from a sophisticated formula known as the Black-Scholes model, which is commonly applied in determining the cost for various financial products, especially options. This calculation involves multiple important elements to predict the potential volatility of the Nifty 50 index over the upcoming month. Here’s an easier breakdown of how it’s done:
- Strike price (K): This is the set price for options on the Nifty 50 index to be sold or bought. It’s typically based on options that are not yet in profit.
- Market price of the stock (S): It’s the most recent trading price of the Nifty 50 index stocks.
- Time to expiry (T): This refers to how much time is left until the Nifty 50 index options are no longer valid, which is usually a maximum of one month.
- Risk-free rate (R): This is the yield on government bonds, often considered the safest investment, and is used for comparison in the VIX calculation. It’s based on the government bonds’ yield that matches the same period as the index options.
- Volatility (σ): This is the key element, and it’s about the expected intensity of price changes in the Nifty 50 index within the next month. It’s not observed directly but inferred from the prices of Nifty 50 index options.
In short, while we can see the current price and the time left for options, the expected volatility needs to be estimated using the available market data.
Understanding India VIX in stock market
India VIX is critical for understanding market choppiness before investing. Since all significant directional market movements are preceded by market choppiness, India VIX plays a crucial role in determining the confidence or fear of the investors.
- A lower VIX signifies low volatility and a stable range for the asset price.
- A higher VIX implies high volatility and a lack of confidence among investors to trade in the current market range. Usually, it is an indication of a significant directional movement in the market marked with the broadening of the current range.
Volatility and India VIX share a positive correlation, which means when volatility is high, the value of India VIX is also high. For example, in the pre-COVID situation, India VIX was significantly low at below 30 since 2014, indicating stability. But since the outbreak of the pandemic, India VIX value reached 50. During the same period, the equity index lost nearly 40% of its value and traded at the 8000 level.
However, a crucial point to remember is that India VIX doesn’t indicate trend direction. It only captures rising or falling volatility factors. Hence, investors with higher exposure to equities keep a close watch on India VIX’s value.
There are instances of extreme volatility and periods when the market moved in a tight range. But India VIX has a tendency to fall back to its mean, between 15-35. There can also be a situation when India VIX reaches zero. In this situation, the index can either double or come to zero.
Planning trade around VIX
VIX measures near term volatility for a period of 30 days. Hence, it uses options with the current month expiry and next month for calculation. It assumes that option premium at the strike price as NIFTY is a reflection of the implied volatility of the overall market.
India VIX considers averaging the order book of NIFTY options as a good measure of market volatility. It uses a complex statistical formula, which you don’t need to learn. But you must understand what it implies to plan trades.
- For day traders, India VIX offers a good measure of market risk. It gives traders an idea of when stock prices go up or down when market volatility changes. For example, when the VIX value rises, intraday traders run the risk of triggering their stop loss level. Accordingly, they can reduce their leverage or increase stop loss.
- Long term investors don’t bother about short term volatility, but in the long run, rising India VIX gives a fair measure of increasing uncertainties when institutional investors can raise their hedge by going heavy on put options to play the market.
- Options traders depend heavily on the volatility metrics for buy and sell decisions. For instance, when volatility rises, options become more valuable and rewarding for buyers. Conversely, in times of low volatility, options tend to lose their value as they reach the expiry.
- There are few ways to trade volatility. Traders can buy straddles or strangles when market volatility rises. But this trading strategy is expensive. Hence, as an alternative, one can go heavy on futures on the VIX index without worrying about market direction.
- India VIX and NIFTY share a negative correlation. When plotted on a timeline of nine years since the inception of VIX, NIFTY reflected an opposite movement. Hence, when the VIX value is low, NIFTY rises and vis-a-vis. It gives investors a fair idea of market behaviour.
- When India VIX value peaks, portfolio and mutual fund managers increase their exposure in high Beta portfolios. Similarly, they would select low Beta stocks when the VIX value is low.
- India VIX is critical for options writers. High VIX value presents options writers with an opportunity of unlimited risk and limited rewards (premium). As the market passes through a phase of high volatility, out of money options contracts can turn into an at the money or even in the money contracts in a matter of few trading sessions.
Let’s understand with an example how options writers use VIX value while writing a contract. Suppose an options writer decides to write a contract for Rs 275 for ABC stocks with a current price of Rs 310. He plans to sell 3000 shares at Rs 10 premium on a seven days expiry contract. With the ongoing market volatility range, contract prices can fall to Rs 230 in two days. Hence, his loss after five days will be.
Strike price Rs 275
Spot price Rs 230
Premium Rs 10
He earns a loss of Rs (230+10) – Rs 275 or Rs 35. His total loss is Rs 105,000 per lot. Hence, ideally, he will avoid writing the contract or charge a high premium if he does.
Conclusion
India VIX is a volatility index to measure the market’s expectation of volatility. It is a powerful tool to gauge the expected price movement of stocks. Historically, high VIX values were followed by a significant shift in share price and indices. It also plays a critical role in determining derivative contract prices and premiums.
Now that you have learned about India VIX meaning go ahead trade with confidence.
FAQs
What is market volatility?
Market volatility refers to large swings in stock prices in the equity market. Usually, securities with high volatility are riskier.
It is measured by the standard deviation of the stock price from the same securities or index.
What is India VIX?
India VIX is the volatility index of NIFTY, introduced in 2008. It is computed using the best bid and ask quotes of the out-of-the-money near and mid-month NIFTY option contracts traded in the NSE exchange. It indicates investors’ perception of volatility in the near future.
What does India VIX suggest?
India VIX measures market volatility. A higher value of India VIX indicates high volatility, and lower values imply market stability. Historically, India VIX and NIFTY exhibited a strong negative correlation. It means, when volatility rises, NIFTY falls, and vis-a-vis.
What is the value of India VIX?
India VIX moves in a range with a median of 15-35. However, it can also reach extremely low or high values under certain circumstances. When India VIX value falls to zero, the index can either double or become zero.
However, India VIX is non-directional, meaning it doesn’t indicate which direction the market will turn. It simply represents the anticipation of volatility by investors for the next thirty days.
Who can use India VIX?
India VIX is used by a wide range of market players, including investors, traders, options writers, portfolio and mutual fund managers. They follow the VIX movement to adjust their market expectations and beta exposure.
How does India VIX affect stock prices?
India VIX is a measurement of market volatility. Usually, when India VIX rises, NIFTY falls, indicating a good time to buy stocks.
What is a poor India VIX value?
Since India VIX moves in a range of 15-35, any value above 35 signifies a condition of high volatility. The value of India VIX spikes during periods of increased turmoil driven by fear factors in the market.
What is the relationship between India VIX and NIFTY?
India VIX and NIFTY had exhibited a strong negative correlation. Whenever India VIX rises, NIFTY falls. Conversely, when VIX falls, NIFTY rises and investors feel more confident with falling volatility.
How to trade in NIFTY VIX?
One way to trade in NIFTY VIX is to purchase exchange-traded funds linked to the volatility index.
