Investors can use the market volatility index to gauge risks

February 2, 2014:

VIX is a trademarked symbol for the Chicago Board Options Exchange (CBOE) Market Volatility Index. It represents the markets expectation of volatility over a pre-defined period.

India VIX is a volatility index based on the Nifty index option prices. From the best bid-ask prices of Nifty options, a volatility figure (in per cent) is calculated, indicating the expected market volatility over the next 30 days.

India VIX uses the computation methodology of CBOE, with suitable amendments to adapt to the Nifty options order book.

The current value of India VIX is 25, which means people envisage that, over the next 30 days, markets can move up or down by 7.21 per cent (25 divided by square root of 12 or 3.46).

So, India VIX divided by 3.46 gives you the range over which the market is expectted to move over the next 30 days. India VIX is computed using the best bid/ask quotes from out-of-the-money, near and mid-month Nifty option contracts, which are traded on the futures and options (F&O) segment of NSE.

Several factors are used in the calculation of the volatility index. Here are some important ones:

Time to Expiry: This is the time left to expiry on the option contract selected to calculate the index. Time to expiry is calculated in minutes instead of days for a more accurate reading.

Interest Rate: MIBOR (Mumbai inter-Bank offer rate) of a relevant tenure.

Forward Index Level: This methodology is adopted to pick which out-of-the money strike is used in computing the Index; and Bid/Ask quotes.

There could be an indefinite number of approaches through which one can benefit from trading the VIX.

Two simple examples of doing so are explained below:

VIX on the higher range indicates the possibility of market volatility going up. So a trader writing options can use this as an indication to analyse the risk. Similarly, if you are following the trend on Nifty futures and want to confirm if the current trend will sustain, a lower VIX indicates the continuation of the trend.

The introduction of VIX has helped traders gauge market sentiment, with many investors already using the VIX to balance portfolios. This aid in making trading decisions and more.

The introduction of futures and options on VIX will be an added advantage to the speculating, hedging, and the arbitrage trading community in India.

(This article was published on February 2, 2014)