The Volatility Index (VIX) has been part off stock market analysis for the last decade. You must have noticed that the Nifty goes up when the VIX is low (below 15) and it tends to go down sharply when the Nifty is above 22. While there is no sanctity to these numbers, the VIX broadly represents the fear in the market and that is why it is also called the Fear Index. When expected volatility is high, the fear factor is high and equity markets react negatively to fear. That explains why you see Nifty and VIX moving in opposite directions.
How exactly is the VIX calculated?
To understand the VIX calculation, you need to briefly go back to the Black & Scholes Model for options pricing. In the model, you input factors like spot price, strike price, volatility, time to expiry and interest rates to arrive at the option value. In VIX calculation you work backward. You assume that the option market price is the correct value and instead you calculate the volatility as the unknown. This is the implied volatility and it is used to calculate the VIX. But that raises another question; which Nifty option strikes to use?
VIX Calculation involves both the current month and next month Out of the Money (OTM) options. In the Money (ITM) and At the Money (ATM) options are excluded from VIX calculation. These bid and ask prices of OTM options are considered for calls and puts. The output you get is the VIX. So, what exactly does the VIX represent?
VIX is about expected volatility and not about actual volatility
Before we get to the interpretation of VIX in the Indian context, remember that VIX is about future volatility expected in the market. The VIX assumes that the price of OTM options fairly reflect the market volatility. If VIX index is currently at 15.3 it can be interpreted as a probable annual variation of 15.3% in the next 30 days. But that is the annualized variation and the monthly variation will be the twelfth root which is roughly 1.19%. So if the Nifty is currently at 11,000, its expected range is 131 points either ways. That means; Nifty could be in the range of 10,869 to 11,131 in the next 1 month assuming volatility does not change. The Sensex may also react and swing and accordingly.
How to interpret the rise and fall in VIX
VIX is an estimate of volatility for the next one month expressed in annualized terms. VIX is also called the Fear Index because it shows the quantum of fear that exists in the market at that point of time. Higher VIX means higher fear, which raises the expectation of future volatility. Let us also see how the VIX interacts with the Nifty?
Over the last 10 years since the inception of VIX, the VIX has gone down and the Nifty has almost doubled. But that is not really important. What matters is how Nifty and the VIX interface during times of sharp spikes and sharp falls in volatility. You will find that any sharp spike in volatility tends to coincide with a fall in the Nifty and vice versa. So how can investors leverage on the VIX?
How traders and investors and traders can use the India VIX data?
Since the VIX is a barometer of expected volatility, it can be used by investors and traders alike. Here are some key takeaways.
Long term investors can tweak their sector exposure and hedges based on shifts in VIX. For example, if VIX is moving up sharply, then investors can shift to defensive sectors or increase their hedge ratio.
VIX adds a lot of value for traders. It is possible to trade VIX futures on the NSE. For example, if you expect volatility in the market to go up, then the VIX would go up. In such a case you can buy VIX futures. Here the trader is only taking a view on volatility; not the market direction. These types of trades are very useful in times of key events or key announcements and policies.
If you look at the long term chart of the VIX, it has been normally ranging between 13 and 17. It has gone as low as 9.5 and as high as 60, but these are exceptions. You can use the median range chart of VIX to trade on mean reversion.
Lastly, VIX gives you the short term range to trade. The Nifty spot range is defined by the VIX and one can go long or short at the appropriate levels.
VIX is a smart way to interpret the markets and trade on volatility. It provides a non-directional approach to markets.