Have you heard of India VIX? Are you keen to learn more about it? That’s what we’ll discuss here today: What is India VIX, its meaning, range, importance for traders and the overall implications.
The year 2020 has been one of the most historic years for the world, and it isn’t even over yet. The year, more than anything, showed cause and effect, sort of a mirror to actions and consequences. As a result, the stock markets also saw major downturns and subsequent rises, but in all that, one particular aspect of the market was highlighted. The VIX indication. Don’t know what it is? Well then, let’s get into it, starting with understanding why is there a need for VIX in the first place.
What is India VIX? Full Form
First and foremost, let’s know the full form of this interesting terminology. India VIX stands for India Volatility Index. In simple words, India VIX is the volatility index that measures the annual volatility of market over the near term. A degree of fluctuation in Nifty 50 Index over the next 30 days and its calculation is based on Black Scholes Model.
India VIX: Importance
As we told, VIX stands for volatility index. Now let’s go breaking it down from language point of view. Volatility, both in finance and generally, means unpredictable rapid movements, from a mean of course. See data makes sense, it almost always does, its why it is one of the most reliable sources of research, informative theory and studies. But here’s the thing. Data also has variables. Now when you study data, you try to make sense of it while taking these variables into account.
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Example to Explain India VIX:
Taking an example, the data shows a stock’s price declining for several years, so you cross check profits, you find out those are declining too. Then you go to the year the decline started, and try to figure out what happened, you discover that there was a change in management in the said year. Now you have both cause and effect, and the data makes sense.
Now imagine doing that for market as whole, trying to determine what its trying to say, and when it is expected to move, and when it does move, how much the movement is going to be? Sure, with enough hours and information, you could do that. These are also the questions VIX gives an estimate about, in an analytical sense.
But the assumption there, the assumption in discovering causality is that information is available to you. In an open economy, that is not always the case.
For instance, one of the factors that majorly affect prices is investor mentality. Now you can’t possibly know whether every trader is bullish and bearish at all possible times to estimate trends. Sure, you could do an extensive survey, like the ‘Seven Countries Study’ (it showed co-relation between fat in diet and chances of a heart attack; basically started the war on fat and obesity as we know it). You could do that, but that’s time consuming, and expensive, so you get the argument right?
Now coming to our discussion on India VIX let’s dig into some deeper details.
What is India VIX? In Detail
The other way you could do that is using the data already available to you. For instance, there can be an estimation of movements of markets, by taking into account prices of shares currently, and the options available for them at a future date. See options are nothing but a contract which provides, well, an option to buy or sell a security at a future date, say next month. That is exactly what Volatility Index does, however, please note that the below mentioned explanation of the process is an oversimplification.
See a share price that is the market price of a company is basically what people are currently willing to pay for a part in the company. So you have current value association. So if you look at majority of data of options, which are nothing but price locked in now but to be paid in future, the difference between the market price now and the strike price of options could give you an idea about the estimated movement of share prices.
India VIX kind of does exactly that, but for entire NIFTY, so you have an idea of how much movement people are expecting with the entire index, and because as we discussed earlier, market prices are just people’s willingness to pay, there is a level of accuracy with this assumption.
India VIX: Calculation
The actual calculation is done by something called Black Scholes Model. It uses five key variables:
- Strike price of the options contract,
- Market price of a stock,
- Time to expiry,
- Risk free rate of return and
Having said that, please note VIX does not tell you the direction of movement; it just tells you the quantum of the movement. This means that VIX does not tell you whether the stock market will go up or down, it just tells you how much it would go in a direction.
In a very adolescent sort of way, India VIX tells you the general greed or fear perceptions related to the market, in the next 30 days.
India VIX is calculated in a percentage format. Here’s where we want your undivided attention. Okay, basics first, a percentage format means it cannot be above 100, and it also cannot be below zero, which you already know because as mentioned before, it just says quantum, not direction. Fun fact, if VIX is 0, theoretically, it means that NIFTY could either go to 0, or double itself.
However, even though VIX represents the movement for next 30 days, it represents annualized movement.
Taking another example, let’s say on July 2, 2020, VIX stands at 24.19. This means for the next month people expect NIFTY to move at 24.19% in the next year. (You might want to read that sentence carefully a couple of times before moving on, if you’re not yet clear, that is.)
But, because we’re talking of an open economy, the role of pricing of options and VIX index are sort of intertwined. See, when NIFTY goes down, VIX goes up, an inverse relation because there is higher expectation of upward movement, because the market now has to deviate back to mean and get growth. Similarly, if options show a huge difference between current sport price and future strike price, VIX goes up because again, increased volatility. But an increased VIX also can result in further increasing that gap, you know, for current market entrants.
What is an Ideal Range for VIX?
Let’s look at another perspective of what India VIX tells you. Because VIX measure volatility, a low India VIX basically means less market movements and shocks, sort of like a boring stagnant steady market. A high VIX tells you that investors expect huge volatility in the coming month, sort of like riding a ship while there is a storm, whirlpool and rain in middle of the sea at night. You know, trading in markets during COVID-19, same difference.
An accurate estimate for ideal range can be done by seeing the market itself, noting its highs and lows. This puts an ideal range for VIX around 15-35, which means markets shouldn’t be too stagnant but not too volatile either.
Like a high India VIX generally indicates more volatile pricing of options. On the other hand, a uniform range depicts options being priced reasonably.
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India VIX: The Bottom Line
India VIX can be useful in both trading equities and options, but a couple of things should be kept in mind. First, it is an estimate, the data purely reflects what people think is going to happen which can change with inflow of additional information and news. Second, it could mean the market could go up, but it very well could go down as well.
So, what can you say about this silent yet useful volatility indicator? How significant is India VIX for the active traders and investors especially in Option pricing? Do share your thoughts on the same.