The term “investments” is always accompanied by some other important terms like “growth”, “returns”, “risk”, etc. And one of the important terms that can shake an investor to the bone is “volatility”. Volatility is the extent to which the investor’s investment value is subject to the market’s mood swings over a certain timeframe. It refers to the uncertainty or risk that is associated with the value of a security. The most common observation regarding volatility is that the higher the volatility, the higher the risk of security. This term “volatility” brings us to a very interesting term, i.e., India Vix.
What is a Volatility Index?
A Volatility Index or VIX computes the volatility that can be expected by the traders in the market by calculating backward from the buy-sell prices of the Nifty options contracts. It reflects greed and fear of the investors and is quite popularly known as the “fear index” or the “fear gauge”. In simple terms, a VIX gives investors an idea about the short-term market expectations, say a month, and captures the market sentiments. Now, a market that is volatile can see a shift in a short span of time and it gets tough for investors to understand and react to this shift, which in turn leads to them getting caught unaware.
The Chicago Board Options Exchange (CBOE) coined the term VIX in the year 1993, post which, India Vix was started by the NSE in 2008, with the permission of the CBOE. As it is popularly known, the India Volatility Index or India Vix is an index floated by the NSE. This index determines the level of fluctuation that active traders can expect in the Nifty50 in the following 30 days. The Black Scholes Model is the basis for calculating the volatility index. It is used to price the options contracts. The Black Scholes Model makes use of five main variables to extract the contract’s ‘fair price’.
What is India Vix?
As indicated earlier, the India VIX is an indicator of the volatility of the Indian market from the investors’ standpoint. The India VIX uses a method quite similar to that of the CBOE to calculate the volatility. Since the India VIX and volatility move on parallel roads, high volatility can be expected when India VIX has a high value, which denotes that traders can expect an interesting change in Nifty and vice versa.
Now, The Nifty and India VIX have a negative correlation, which means that Nifty sees a rise when India VIX drops and vice versa. This is visible in the historical data as well. Let us look into an example from the recent past where India VIX had reached a peak – in the year 2020, the rise of Covid-19 along with the lockdown measures imposed led to India VIX hitting a high of 83.6075 on 24th March 2020 and Nifty tanked from its highs of 12000 to 7800 approx.
Typically, though India VIX and Nifty50 are negatively correlated, a few instances took place in 2010,2014-15, and 2017-18, where these two indices rose together. However, when the VIX bottomed, the index also started falling with it and the market saw some corrections between 3-8%.
You could get the historical data of these indices at NSE India and understand the correlation between these two. Investors must learn to interpret this data and the level of fear or complacency associated with the India Vix data.
Importance of India Vix
If your portfolio has a major stake in equities, playing safe is the best bet. This Volatility Index indicates the volatility of the Indian Stock Market from the standpoint of the investor. It represents the annualized change that one can expect in the Nifty50 during the upcoming 30 days. Let us understand this better with an example – assume that, at a specific time, the India VIX stands at 11.97. This indicates that for the following 30 days, the investors can expect Nifty to shift in either direction by the annualized rate of 11.97%. Another method to read these Vix scores is to compare the current value of India Vix to its 52-week low and high scores, or you could even check it out for a longer time. If you pull out historical data, you will see that the Vix reached a high of 85.13 in November 2008 after the Lehman Brothers’ collapse. In the last 5 years, the Vix has remained below 30, and in 2017, it has seen a low of 8.83. However, on March 24, 2020, it reached a high of 83.6075 posts the outbreak of Covid-19. The India Vix data helps investors assess market risk and make wise decisions on their investments.
What does the Volatility Index (VIX) indicate to the markets?
The VIX depicts the expected risk or volatility in the markets, however, an investor must understand how to apply the data practically. Let us look at some of the ways of using the data:
1. For those who trade inequities, an excellent measure of assessing the market risk is via the VIX, as it provides an idea of the movement of market volatility to the intraday traders as well as short-term trades. This helps the trades to adjust their strategy suitably. For instance, if there is a likelihood of the volatility shooting up, the risk faced by the intraday traders is that their stop losses might get triggered quickly, and they could either stretch their stop losses or minimize their leverage accordingly.
2. Even the long-term investors can benefit from the VIX. On a general basis, long-term investors aren’t quite worried about the short-term market volatility. However, institutional investors as well as proprietary desks have certain limitations with regard to MTM losses and risk. When the VIX indicates a rise in volatility, these investors can extend their hedges by way of puts and thereby play the market in both ways.
3. VIX is quite useful even to trade volatility. If investors expect a lot of volatility in the markets then they could purchase straddles or strangles. However, when volatility rises, this could turn out to be quite expensive. Instead, they could purchase futures on the VIX index to benefit from the volatility without being perturbed about the movement of the market.
4. VIX is of use even to those who trade-in options. Normally, buying or selling an option depends on volatility. Options tend to become valuable when volatility is expected to rise and buyers are prone to gain more. When there is a fall in VIX, option sellers are prone to benefit from it.
5. VIX is a reliable and excellent measure of the index movement. Markets tend to peak when the VIX falls and vice versa. This input is quite useful for index trades.
6. It is an indispensable tool for mutual fund managers and portfolio managers. When the VIX peaks, they can consider increasing their exposure in a high Beta portfolio, and when the VIX falls, they can consider adding low beta stocks. The India VIX is a great tool to gauge the risk and volatility of the market and is helpful to long-term and short-term investors, institutional investors, mutual fund managers, traders in futures and options, etc. This tool could be used by one and all to understand other investors’ perceptions and help you make some wise decisions in the equity market.