Learning Volatility Index & What Does It Indicate

The stock market is dynamic in nature. It never remains steady because it always fluctuates on either side. It either rises or falls depending on various factors. The market movement on either side in excess of normal behaviour is termed as volatility. The measure that measures this sharp market movement is called Volatility Index (VIX). While writing this article, the India VIX, constructed by the NSE, was up by 5.14 per cent at 14.83 compared to its opening level of 14.10. The 52 week-low level of the index is at 11.95. The Indian VIX is currently trading 30.42 per cent lower compared to its one month, and trading 52.45 per cent lower compared to its one year ago level.

Normally we have witnessed sharp rise in the VIX during times of extremely volatility or global geopolitical crisis. This is a trend we have seen quite often in the Indian markets. The VIX is also popularly referred to as the Fear Index as it shows the amount of fear in the market and that is why a high VIX is normally indicative of panic and a precursor to a sharp fall in the markets. In fact, if you plot the VIX chart and the Nifty chart, you will find a clear negative correlation between them as markets tend to be positive when the VIX is lower, indicating volatility is under control.

How is the VIX constructed and monitored?

VIX typically measures the very near term (less than 1 month) and that is why it uses the options for the current month expiry and the next month to calculate the VIX. In the early part of the series, it focuses purely on the current month but as the series progresses, the calculation of VIX factors in the next month too, so as to make the measure more realistic. What the VIX assumes is that the option premium on key strikes of the Nifty reflects the implied volatility in the markets overall. Hence averaging them can give you a good picture of the volatility that the options are pricing in. Typically, options prices (both of calls and puts) tend to show higher prices when they show higher expectations of volatility. The India VIX is calculated based on the order book of Nifty options. So effectively, the VIX in Indian markets basically takes the option price quoting in the market and then it works backward and measures the volatility implicit in the pricing. If the entire option set is assuming higher volatility, then the VIX will also be high.

The NSE collects the data and disseminates the VIX on a regular basis. In the Indian markets, you can not only gauge the volatility in the market by VIX but you can also trade the VIX and just trade the volatility rather than trying to take a directional view on stocks and indices.

What are the four key things that the VIX tells you?

While the VIX is a simple depiction of the expected volatility or risk in the markets, the bigger question is, what are its application in the market and how do we use it practically?

1. For traders in equity, the VIX is a sound measure of risk in the markets. It gives these intra-day traders and short-term traders an idea of whether the volatility is going up or going down in the market. If volatility is going up then traders need to cut their leveraged positions and try to play volatility through options.

2. VIX is also a useful indicator for the options traders. The decision to buy or sell an option is based on volatility. When the volatility is likely to rise, options (both calls and puts) are likely to become more valuable and buyers tend to gain more. When the VIX is coming down there will be wasting of time value and option sellers will benefit more.

3. VIX is a gauge of the index movement. If you plot the VIX and the Nifty movement for the last 9 years since the inception of VIX, there is a clear negative correlation. Markets tend to peak out when the VIX is bottoms and the markets tend to bottom out when the VIX peaks. This is a useful input for index trades.

4. VIX is also useful for portfolio managers and for mutual fund managers. They can look to increase their exposure to high Beta portfolio when the VIX has peaked (a VIX peak is a market bottom). Similarly, they can also add on to low beta stocks when the VIX has bottomed (a VIX bottom is a market top).