If you are familiar trading in the futures and options space, you would have come across a contract called the VIX contract. Like you trade index futures and stock futures and options, you can also trade futures on the NSE VIX contracts. What exactly is the VIX contract and how is it calculated? VIX is a measure of volatility in the market, which is why it is called the volatility index. In common parlance it is called the Fear Index since a higher level of VIX represents a high level of fear in the market and a low level of VIX indicates a high level of confidence in the markets.
Let us look at how to trade VIX and some India VIX trading strategies. Do you know that there is a negative correlation between India VIX and the Nifty? Here are the few things you need to know about VIX. But, first the chart below captures the VIX values in the last one year.
Chart source: NSE
Remember, VIX is about market expectations of volatility
VIX typically measures the near term and hence it uses the options for the current month expiry and the next month to calculate the VIX. 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. The best bid-ask quotes of the near-month Nifty options and next-month Nifty options are considered. The India VIX reflects the expected volatility in the next 30 days. The statistical formula to calculate the India VIX is as under:
While the formula is just for understanding purposes, the VIX is calculated and disseminated by the NSE on a real time basis. What you need to actually understand about the VIX is its interpretation and what it indicates to you.
6 things that the Volatility Index (VIX) indicates to the markets..
While, the VIX is a simple depiction of the expected volatility or risk in the markets, the bigger question is how to apply it practically. Here are 6 ways to do it:
1. For traders in equity, the VIX is a very good and sound measure of risk in the markets.It gives these stock traders who are in intraday trading and short term traders an idea of whether the volatility is going up or going down in the market. They can calibrate their strategy accordingly. For example, when the volatility is likely to shoot up sharply, the intraday traders run the risk of stop losses getting triggered quickly. Hence they can either reduce their leverage or they can widen their stop losses accordingly.
2. VIX is also a very good indicator for the long term investors. Normally, long term investors are not overly bothered about short term volatility. But institutional investors and proprietary desks have limitations in terms of risk and MTM losses. When the VIX gives an indication of rising volatility, they can increase their hedges in the form of puts to play the market both ways.
3. VIX is also a useful indicator for the trader in options. Normally, the decision to buy or sell an option is based on volatility. When the volatility is likely to rise, options are likely to become more valuable and buyers tend to gain more. When the VIX is coming down there will be more wasting of the time value and option sellers are likely to benefit more.
4. It is also useful to trade volatility. In case you are expecting the markets to become more volatility one strategy is to buy straddles or strangles. But these become too expensive when volatility is likely to rise. A better way would be to buy futures on the VIX index itself so that you benefit from volatility without worrying about the direction of the market movement.
5. VIX is a very good and reliable gauge of the index movement. If you plot the VIX and the Nifty movement for the last 9 years since the inception of VIX, you will see a clear negative correlation in the charts itself. Markets typically tend to peak out when the VIX is bottoming out and the markets tend to bottom out when the VIX is peaking out. This is a useful input for index trades.
6. VIX is an invaluable tool for portfolio managers and for mutual fund managers. They can look to increase their exposure to high Beta portfolio when the VIX has peaked out and they can add on to low beta stocks when the VIX has bottomed out.
India VIX is just about 9 years old but has already emerged as a veritable tool for gauging the risk and volatility in the market.