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6 Things That the Volatility Index (VIX) Indicates

19 Apr 2024

Introduction

The Volatility Index, also known as the VIX or the "Fear Index," is important. By assessing the degree of uncertainty and price swings, it depicts market volatility. The VIX contract, which is comparable to index and stock futures, is used by traders as a tool to assess market mood. A higher VIX indicates greater investor apprehension and market instability, whereas a lower VIX suggests greater market confidence. The "India VIX Index" calculates market volatility in India using the NIFTY 50 index. This index provides information on expected price volatility over a 30-day period, which aids traders and investors in selecting the best moments to purchase and sell.

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.

In simple terms, the VIX or the volatility index, in India called the “India VIX Index”, means that the stock markets in India use the NIFTY 50 to estimate any volatility in the markets. This is primarily a tool that helps investors and traders to make the decisions of when to buy and to sell shares. Mainly, the VIX acts as a reference with regard to the volatility of prices in the markets for a period that spans around 30 days. Essentially, the VIX gets traders and investors to identify the effect of any expected volatility that may occur in the stock markets.

Let us look at how to trade with the 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 (mark to market) 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 volatile one strategy is to buy straddles or strangles. These are strategies in options trading. 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 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.

The India VIX ideal range

The VIX is a tool that is used in most major markets around the globe, and pertains to the country in question’s index. The India VIX meaning pertains to the VIX as a measure of market volatility as it relates to the NIFTY 50, and the stocks included in this index. In theory, the value of the VIX tends to move in the range of 15 to 35 units. The corresponding price fluctuation range is somewhere in the range of +15 to -15. This is taken to be indicative of values for a period of a month, or 30 days. Therefore, if you discover that any value is near about 15, it implies a low degree of volatility. On the other hand, any values that are close to 35 show high volatility. 

Why the NIFTY VIX today is important

Today, any and every investor and trader seeks ways to make their stock trading and investing activity as easy as possible. This is because everyone ultimately aims for gains from the stock market. Knowing very well that volatility of prices plays a key role in trading performance, the VIX can be used effectively by investors to make estimates about stocks and formulate their techniques to trade accordingly. 

The India VIX and the factors that produce volatility move in alignment with each other. So, if the value of the India VIX index shows a rise, then the expectation of traders should be a high level of volatility. This translates to a considerable shift in the NIFTY index. If the value is low, this indicates a lower expectation of volatility, and that means hardly any change in the NIFTY index itself. 

A Dependable Tool

The India VIX displays a negative correlation with the NIFTY index as well. When the India VIX decreases, the NIFTY rises, and when the India VIX goes up, typically, the NIFTY drops. 

The 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. It has been reported that both seasoned investors and those who are just starting out as traders use this tool to effectively maneuver the share markets with some ease. Moreover, the tool has proved dependable and reliable, and is not likely to let you down when you trade. The primary reason for individuals to avoid the markets is the risk of market volatility. However, the study of the VIX and its use can do a great deal to alleviate apprehensiveness to try stock trading. 

 

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