Most of you must have heard of VIX as the measure of volatility in the markets. VIX actually stands for Volatility Index and it is derived from the concept that was first used by the Chicago Board of Exchange, also called the CBOE-VIX. The VIX is also called the Fear Index and the India VIX has been consistently measured since 2009 and data is available on a real time basis.
The VIX index is the underlying in this case. Normally, you would have seen that VIX goes high in times of uncertainty and then the market corrects. Historically, the relationship between VIX and Nifty has been negative. The Nifty has reacted negatively to a sharp rise in the VIX but has reacted positively to a fall in VIX. VIX is a measure of volatility in the market and 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.
VIX measurement and interpretation
VIX uses the Black & Scholes model but uses the volatility as the unknown. It uses the market price of options as the fair value and then goes backward to calculate the implied volatility. VIX is calculated by taking an average of the most liquid options in the near month contract. Note that mid month and far are not considered. 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 as to make the measure more realistic. The VIX assumes that the option premium on key strikes of the Nifty reflects implied volatility in the markets overall. Hence averaging all these implied volatilities can give a good picture of the volatility that options are pricing in. Options prices show higher values 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.
Let us look at the mathematical formula for VIX although you do not get into the nuances of Black & Scholes. It is possible to get these numbers readymade on your screen and you need to focus more on the interpretation. Here is the formula for calculating implied volatility.
The NSE collects all this data and disseminates the VIX on a real time basis. You need to focus more on what the VIX tells you and how to actually trade in VIX.
How exactly should you interpret the VIX data?
VIX is a simple depiction of the expected volatility or risk in the markets and it is a very short term perspective and only considers the next one month:
For equity traders and even for investors in equity, VIX is a measure of risk that implied in the markets. For equity investors, volatility is risk and that has to be managed. The VIX rising is an indication that they need to focus more on managing the risk going ahead. The trader can tweak the position accordingly. For example, if volatility is going up, traders need to cut leveraged positions.
VIX is also a useful indicator for the options traders. While equity traders and investors are generally wary of volatility, the options traders actually love volatility because it increases their chances of making profits as long as they are buyers. Volatility works in favour of the buyer of options and against the seller of options. Both calls and puts become more valuable when volatility rises and buyers stand to gain.
VIX is a good gauge of the index movement, especially when it comes to identifying turnaround points. If you plot VIX and Nifty over a longer period of time, there is a clear negative correlation. Markets tend to peak when the VIX bottoms out and the markets tend to bottom out when the VIX peaks.
VIX also helps portfolio managers to tweak their hedges, portfolio betas and portfolio risk metrics based on the VIX outlook. They can increase exposure to high Beta portfolio when the VIX has peaked (a VIX peak is a market bottom). They can also add on to low beta stocks when the VIX has bottomed (a VIX bottom is a market top).
How to trade VIX on the NSE
NSE VIX futures are traded on the NSE under the symbol of NVIX. The advantage of these futures is that you can take a view on volatility without worrying about the direction. For example, if you have a portfolio of stock and want to protect against a potential rise in volatility, then you can do so by buying NVIX futures. As the volatility moves up, the futures become more profitable.