The stock market is known for its fast and unpredictable movement, like a hurricane. While the indices, such as Nifty 50, will give you an idea of where the Stock Market is heading, they won't tell you how much fear is in the market. This is where the India VIX comes into play.
The India VIX is often referred to as the "Fear Gauge." The India VIX is a key factor for all the traders, options traders, and long-term investors, and understanding its purpose and computation will help you understand market risk better.
We will provide you with a complete guide on the India VIX: its definition, method of calculation, and how it can be beneficial to help improve your trading strategies.
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What is India VIX?
The India VIX is a proprietary index designed by the National Stock Exchange (NSE) in India that dates back to 2008. The India VIX is modelled on the CBOE VIX Index in the USA.
To simplify the definition, the India VIX indicates what the Stock Market estimates the market to look like in terms of volatility. Specifically, the India VIX measures the expected volatility of the Nifty 50 Index for the next 30 calendar days.
The India VIX will NOT predict the Market Direction (the Nifty 50 will go higher or lower), but rather estimate the size of the price movement.
High levels of market volatility, whether they occur as a result of political uncertainty prior to important elections or as a result of global issues, often create panic among investors. As a result, many traders use Derivatives Markets to hedge against the potential loss of capital. Due to this excess demand for hedging, the India VIX increases.
What India VIX Represents?
The India VIX represents expected market movement for a year as a percentage.
For example, if the India VIX reading at the time was twenty, the market was suggesting that the future expected movement of the Nifty 50 Share Index would equal approximately twenty percent either up or down during that time period.
How to Convert VIX to the 30-Day Expected Range?
To get the most out of the VIX when investing in shorter time frames (less than 1 year); you need to convert the VIX reading to 30-day movement expectations. The standard method for converting an annualized number (i.e., VIX reading) to a 30-day reading is to divide the annual VIX number by the square root of 12 (the total number of months in a year).
Using our example:
When applying this conversion method, you would reach an understanding that, based on the current VIX reading, you can expect with a 68% accuracy rate that the Nifty 50 will fall within +/- 5.77% during the next 30 days. This analysis is critical for options traders when they create their trades. Looking for more information regarding options? Visit our “Understanding open interest in Derivatives” and also check out our “How to Start Trading in Derivatives Markets in India”.
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How to Interpret India VIX Values?
By examining the behaviour of the VIX Index, we can determine how traders are feeling about future price movement.
A high India VIX indicates that traders are consistently adding to their positions with regard to hedging their portfolios, as there is increasing demand for put and call options associated with the increased level of implied volatility of those options.
India VIX and Nifty 50 Correlation
There is a clear inverse correlation between the India VIX and the Nifty 50. Specifically, when there is an unexpected sharp drop in prices on Nifty, India VIX begins to move higher. As traders panic, they aggressively short the Nifty; operationally, this results in aggressive hedging of their short positions. Hence, the cost of options will accelerate, and the value of the Indian VIX will increase.
However, when the Nifty begins to trend higher and remains in a long bullish trend, the India VIX will continue to decay and remain in a state of low volatility (i.e., low teens). In these cases, trader complacency offers an opportunity for them to further reduce their need for hedging their long positions; therefore, the VIX Index will decrease significantly.
The inverse correlation between the India VIX and the Nifty enables a technical analyst to use the VIX Index as an additional confirmatory tool to further substantiate their technical analysis.
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Calculation and Formula
India VIX calculation utilizes sophisticated calculation processes. The main point of reference in the calculation process is implied volatility.
The Role of Implied Volatility
Calculated monthly, the India VIX is derived from the value of the option contracts currently being traded at this time (near-month), including the next month's option contracts (next month) related to the Nifty 50 Index.
Implied Volatility is the expectation of how the market will price the underlying asset, based on the price the market has set for the current option contract(s) with respect to its expected future volatility. The value of the implied volatility is approximated backward through current option premiums, typically through the application of the Black-Scholes (or other pricing models).
High prices for call and put options indicate that traders are expecting a high amount of market volatility (known as Implied Volatility (IV)) and when using mathematical models to calculate market volatility in India (as measured through India's Volatility Index (VIX)), a high level a high level of volatility expectation would also be expected to be reflected by the India VIX.
Simplified Calculation Steps
The National Stock Exchange of India Limited (NSE) uses the methodology that was originally created by the Chicago Board Options Exchange (CBOE) and can be viewed in the following manner:
Stage 1: Selection of Options: The NSE chooses a wide variety of OTM Call and Put options that are located within two months of the upcoming Nifty 50 expiration dates.
Stage 2: Calculation of the Variance: The IV values of all selected options are calculated, and the weighted average IV values (measured using variance) are combined across both expiration dates.
Stage 3: Interpolation: A mathematical interpolation is used to create one continuous "30-day" estimate of volatility from the variance measure found in stages one and two above.
The simplified formula to arrive at the VIX value is:
To summarize, although the complete math behind the Calculation of the India VIX is complex, it is helpful to understand that this is an aggregate expected volatility of the Indian Stock Market as reflected in the prices of options that are bought and sold on the NSE.
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Conclusion
The India VIX Index reflects more than just a statistical number found on an NSE trading screen; it represents the aggregate (in real-time), the collective “fear” or doubt of the sample population, as well as the uncertainty in that sample population’s opinions about the future of the Indian Equity markets.
An understanding of the India VIX's meaning and how this index behaves in relation to the Nifty 50 allows you to progress past only looking at price charts and be able to consider the psychology behind the market when making trading decisions. Whether you are an individual investor trying to determine risk levels or you are an individual trading options on the stock, understanding how the India Volatility Index functions will equip you with more knowledge to become a better trader and increase your profitability.
If you are new to trading stock, you may want to check out the following guides to help get you started in your investing journey: Equity Market Basics, as well as How do I Start Trading in the Stock Market as a Student?
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