We all know that the stock market is volatile.
Amid this volatility, there is a certainty crisis and every trader/investor has a burning urge to predict the future of the Stock Market.
VIX is one such parameter that indicates the volatility of stocks indices.
VIX is outlined in such a way that, it indicates the investors’ perception of the annual market volatility over a time period of the next 30 days.
Therefore, the higher the VIX, the higher the expected volatility and likewise.
In this blog article, let’s understand all about VIX, its importance and the way experts predict markets with it!
Experts glance at VIX values as a way to analyse market risk, growth, fear before they take investment decisions.
Therefore, apart from the Volatility Index, VIX is also termed as a parameter with which we can gauge fear and hence also know a Fear Index.
If you follow news on regular basis, it is no surprise for you that, when one utters ‘VIX’, for the US stock market it’s the volatility of the S&P 500 index based on S&P Options and for India Volatility Index is based on the NIFTY Index Option prices.
Hence it is called India VIX.
Note that the Volatility Index is referred to as the index and not stock.
In the Indian Stock Market, Sensex & Nifty have favoured indices but VIX is available for Nifty50 only!
Strange!?
Let us understand why!
VIX is a number and it is dynamic, meaning that it changes like stock prices in the day, every moment.
It is represented as a percentage.
Ironically, if the anchor in the news say “Today India VIX is 20”, it means on a particular given day one can expect the Nifty to be between +20% and -20 % from today’s price of Nifty.
This price will be true for the next 1 year for the next 30 trading days.
And the parity of truthfulness is checked by the confidence level of the standard deviation of the normal probability curve which is 68% always.
VIX is derived from index option prices, using the best bid and asks quotes of the out-of-the-money near and mid-month NIFTY option contracts traded on the Derivatives segment of NSE.
This is done by analysing the options investors are buying and selling.
Investor sentiments play a major part in giving clues.
Note that if VIX is high, without any doubt one can expect higher volatility which eventually means there would be big stock market movements.
When VIX falls it means that there is higher certainty and market confidence is high and the herb mentality aligns towards one direction of the trend.
When VIX rises it shows there is fear, greed and indecisiveness in the markets and the market would go side-ways in the coming days.
VIX proves handy for people who trade Nifty options, to be precise the option writers!
For example, shorting options above in the monthly range.
Technically, volatility is the rate and magnitude at which prices change.
In 2008, NSE started the India VIX, which uses the computation methodology of CBOE, with modifications to adapt to the NIFTY options order book using cubic splines, etc.
On normal days (non-covid days) the India VIX is between 13 to 25%.
VIX had spiked to high levels on the day of the twin tower attack in the US(9/11), also during the election in the year India VIX witnessed an unusual spike and finally not to forget on the 24 Mar 2020, VIX reported being 86.63 due to Coronavirus pandemic.
Let’s dive into the technicals of VIX
The concept of understanding fear and greed in technical terms first was stated in the publication of the Black and Scholes 1973 paper.
These numbers were then followed by ‘The Pricing of Options and Corporate Liabilities’ which was published in the Journal of Political Economy, which also introduced the seminal Black–Scholes model for valuing options.
Note that the VIX calculation’s foundation lies in Black Scholes Model which is used to price options contracts.
Now that you understand the roots of this parameter, let’s understand the relation between India VIX and Nifty, and how the market reacts accordingly.
Correlation of India VIX & Nifty
Now that we have understood VIX, it’s no surprise that India VIX is a numeric representation of fear, greed or risk factor in the stock market.
Therefore, an increase in India VIX simply means fear in the market is rising and therefore the market should fall.
From this, you might have already concluded that there is an inverse correlation between India VIX and Nifty.
Logically, when the India VIX is trending, the market is expected to fall, many option writers will buy put options.
Hence, the premium for these put options increases as a result VIX will increase.
So, the inverse is true when VIX is at its low level and the index is at its high point, and the VIX is at high levels when the market is trying to find a bottom.
But there have been instances when Nifty and VIX rose together and the inverse correlation between the two didn’t hold true.
This happened in 2014 in India during the General elections.
In such instances, when the market rises, i.e when the herd mentality concentrates on buying call options, the premium becomes volatile, hence the VIX rise!
In the same circumstances, bears present in the market tremble, hence VIX again shows fear or for bulls’ greed.
So as VIX reflects fear and greed, the market always co-varies negatively with fear.
As of now, it is safe to conclude that VIX is a good measure of risk perception of the markets.
The higher the VIX, the higher is the volatility and uncertainty.
That is the essence and link between the Nifty index and VIX.
Note that:
“If the India VIX is decreasing then it means that the market should go up due to low risk and fear. If VIX is high then the market would fall and if the VIX falls then the market would rise.”
How does VIX predict the future?
Now that we know the market sentiment based on VIX, one can have a rough glimpse of the future!
Options Traders can form zillions of trading strategies based on the India VIX.
While comparing the historic VIX and analysing it with the current value to the 52 weeks high and low of the values one can come up with a firm trading decision.
Remember, when the VIX is closer to the lower band then, there is a higher possibility of expecting a huge rally coming up in Nifty soon!
Likewise, a trader exists his position when the value is touching the upper band.
There is no denying the fact that sentiment plays a vital role in decision making for the investors, and traders and to that extent, one glace at the VIX could help save or make money.
But before relying completely on VIX, a trader/investor must emphasize specifically the ratio/weights they might ‘peg’ on because no parameter is perfect when considering it on standalone analysis.
Hope you enjoyed reading this blog article!
Until next time…