Anyone who has ever made stock market investments might have wondered if only there were a tool to predict market movement. What if we could get a warning or a signal beforehand that the market will go up or down?
What if I told you that there is one tool that can do that? The VIX!
Short for the Volatility Index, the VIX is an index that measures the market’s expectation of volatility of the benchmark. It determines whether the stock market will be highly risky or less risky. When the market moves rapidly up or down, the VIX rises. Remember that it only predicts the scale of movement in the market and not the direction of the movement.
The Chicago Board Options Exchange (CBOE) first introduced the concept of a volatility index in 1993. It is also known as the Fear Index. The CBOE VIX was based on the S&P 500 index. “VIX” is a trademark of CBOE. The NSE has licensed it from Standard & Poor’s to use it in India VIX.
Now, let’s understand this important concept and learn more about the index’s Indian counterpart and how it relates to investors in India.
Introduced in 2008, the India VIX is a volatility index that measures the expected fluctuations in the NIFTY 50 index over 30 days. It calculates the price swings in the upcoming days. It depicts the predicted rate and magnitude of price changes in the near market.
When there is little to no fear in the market, investors are confident, and thus, the value of the index is low. On the other hand, a higher India VIX value means higher volatility indicating increasing risk and fear in the market.
The India VIX usually trades within an ideal range of 15% to 35%. Although, there have been circumstances where it has crossed this range. For instance, at the time of the COVID-19 lockdown announcement, the index spiked over the level of 70%.
Understanding the India VIX values can help investors and traders gauge market volatility and make informed decisions and risk management strategies.
Traders can judge the market fluctuations and set stop losses and targets accordingly. It can help portfolio managers determine when to enter high or low-beta stocks for the maximum possible returns. Investors can use it to avoid losses in a volatile market.
How Is India VIX Calculated?
The National Stock Exchange (NSE) calculates the India VIX to determine the volatility the market expects over the next 30 days. Just like the CBOE VIX is based on S&P 500, its Indian counterpart is based on the NIFTY Index and calculated similarly.
The calculation of the VIX uses the Black and Scholes (B&S) model, which estimates the price of futures and options contracts using the impact of several variables– spot price, strike price, time of expiry, volatility and the risk-free interest rate. While calculating VIX, you have to work backwards, i.e. the cost of the options contracts is given while the volatility is considered unknown.
India VIX is calculated using the best quotes of the near and next month’s Nifty Index Option contracts traded on the exchange’s Futures and Options (F&O) segment. Only Out of the money (OTM) options are considered since they do not include intrinsic value.
The other four main elements in calculating the India VIX are the time to expiry, interest rates, forward index level and bid-ask price. Let’s go through them one by one.
1. Time to expiry: India VIX uses the put and call options in the near and next month expiration, whereas the CBOE VIX rolls to the next and far month expiration. The expiry time is taken in minutes rather than days for precise calculations.
2. Interest rate: When determining the risk-free interest rate for the respective expiry months of the NIFTY options contract, the relevant tenure of NSE Mumbai Inter-Bank Offer Rate (MIBOR), which is 30 to 90 days, is considered.
3. Forward index level: The forward index level is the latest available price for the NIFTY futures contract for the expiry month. It is used to determine the at-the-money (ATM) strike. Nifty Call Option contracts with strike prices above the ATM strike and Nifty Put Option contracts with strike prices below the ATM strike are considered OTM contracts while calculating the index. Hence, the forward index level is vital in calculating India VIX.
4. Bid-ask quotes: The best bid and ask quotes of the identified OTM contracts are used to calculate the India VIX. The quotes are then used to calculate the variances for near and mid-month expiry by providing weightage to each NIFTY option contract. The variance is the volatility squared.
The variances are then interpolated to get a single variance value with a maturity of 30 days. The square root of the final variance value, when multiplied by 100, gives us the India VIX value.
NIFTY And VIX
Nifty is a market index calculated based on underlying stock price movements and determines the market’s direction. On the other hand, India VIX is a volatility index based on Nifty and predicts the momentum of price fluctuations in the market. Nifty is represented in terms of points, and India VIX is a percentage value.
India VIX and Nifty have a negative correlation. Since the inception of VIX, Nifty has reflected an opposite movement from that of the volatility index. Meaning when the VIX value falls, that of the Nifty rises and vice versa. But it is important to note that when the VIX is high, the market can move sharply in both directions since the VIX only indicates volatility and not the direction the market will move in.
Let’s understand this correlation with the help of an example.
Assume the India VIX is trading at 12. This would mean that traders expect 12% volatility over the year. So, the movement in Nifty is likely to range between -12% to +12% from its current value. If the current level of Nifty is at 18,500, the expected upside for the year would be 20,720, and the downside would be 16,280. We can also calculate the monthly movement by dividing the VIX value by the square root of 12.
The 15-year-old India VIX index helps traders and other market participants understand and navigate market volatility. It is a reliable indicator of market risk perception and an essential market analysis component.
For traders, it is crucial to catch changes in market volatility and adjust their strategies accordingly. By closely monitoring India VIX, traders can anticipate potential shifts in the market and make informed trading decisions.
India VIX is not only beneficial for traders but also for investors. It helps investors gauge the expected price movement of stocks and indices. By paying attention to India VIX, investors can gain insights into market sentiment and adjust their asset allocation based on shifts in market volatility.