A K Agnihotri: Meaning of Volatility Index

The NSE VIX at 33.3 is at its highest. VIX Index is also called the fear index. The higher the VIX, greater the chances of dramatic moves — up or down. Considering the dramatic fall in the stock markets, the high VIX?foretells of extreme risk perception of market players. I am reproducing an erudite paper on VIX. If you can’t understand it, then forget getting concerned about markets and watch Sheila ki jawani. If that causes volatility at your home, then drown your sorrows in more volatile fluids which allay all misgivings and reduce stress. Enjoy!

Volatility Index (VIX) is a key measure of market expectations of near term volatility. As we understand, volatility implies the ability to change. Thus when the markets are highly volatile, market tends to move steeply up or down and during this time volatility index tends to rise. Volatility index declines when the markets become less volatile. VIX is sometimes also referred to as the Fear Index because as the volatility index (VIX) rises, one should become fearful or I would say careful as the markets can move steeply into any direction. Worldwide, VIX has become an indicator of how market practitioners think about volatility. Investors use it to gauge the market volatility and make their investment decisions.

It is important to understand that Volatility Index is different from a price index such as NIFTY or Sensex. The price index measures the direction of the market and is computed using the price movement of the underlying stocks where as Volatility Index measures the dispersion or variance or change and is computed using the order book of the underlying index options and is denoted as an annualized percentage.

VIX was first introduced by the Chicago Board of Options Exchange (CBOE) as the volatility index for the US markets in 1993 and it was based on S&P 100 Index option prices. The methodology was revised in 2003 and the new volatility index was based on S&P 500 Index options. CBOE also introduced VIX options and VIX Futures.

NSE has also started real time dissemination of India VIX which is one step towards introduction of India VIX derivatives. India VIX futures and India VIX options can be used to hedge the risk of market volatility.

NSE is soon going to start India Vix Futures trading which is going to be the first instrument based on the volatility index for India. It’s a very good product and very relevant for the current stock market conditions and also very necessary for the Indian markets to have a product based on the market volatility if we want to make India, a developed and matured market.

The contract specifications like contract lot size, tick values, margin requirements are not yet out but the real question is whether it is going to attract enough liquidity or not? Right now, there are only two exchanges which have successfully launched instruments on the volatility index in the world, VIX by CBOE and VSTOXX by Eurex. Other exchanges tried but failed to make it popular among the traders.

•           Germany’s stock exchange, DTB launched VOLAX futures on DAX in Jan 1998 but has to withdraw the product in the same year in Dec 1998. We may say markets at that time may not be ready to accept this product.

• CBOE successfully launched VIX Futures in March 2004.

• CBOE launched DJIA volatility Futures in Apr 2005, continued it for 4 years but has to delist it in Aug 2009.

• Eurex lists futures on VDAX, VSMI, and VSTOXX in Sep 2005 but has to delist each one of them in Jul 2009. VSTOXX however was relaunched as mini again.

• CBOE successfully lists VIX options.

• CBOE lists Nasdaq and Russell 2000 volatility futures in Jul 2007 but failed and delist the contracts in Feb  2009  and Feb 2010 respectively.

• Eurex lists options on VSTOXX in Mar 2010.

Looking at the history of volatility index products in the world arena, there are more failures then successes when it comes to instruments on volatility index and hence there is a huge question mark on whether IndiaVix is going to be successful or not. In India, high market volatility and absence of other developed products to hedge volatility risks may make IndiaVix a success. Some other exchanges are also coming up with volatility futures like VKOSPI futures, Japanese VIX futures. Only time can tell if these instruments can attract enough traders to sustain required liquidity and depth

The call and put options pricing is dependent on the following factors

1) Price of the underlying

2) Strike price

3) Risk free rate of interest

4) Time to expiry

5) Volatility

Out of these five factors, first four are factual in nature. You know the price of the underlying, strike price, risk free rate of interest, time to expiry at the time of writing an option. What you don’t know is the volatility in the near future and thus it is somewhat subjective in nature and derives from the anxiety or fear of the option writer. This volatility is called implied volatility and it reflects the sentiment of an option writer. If the option writer thinks that in the near future the volatility is going to be high, he would demand higher premium for writing an option and thus the prices of the options will be higher. On the other hand if he thinks the volatility is going to be lower, he will demand lesser premium for the options and thus lower option prices.

Now if we consider all the option writers present in the market. There would be millions of such people and if we try to calculate the average volatility from the options they have written, we can get a value which can describe the overall sentiments of the market about volatility. This is what Volatility Index really tells us. It uses the prices of the options to guess the future volatility, of course, after doing several other operations as well but in a nutshell, it is the reverse process of option pricing taken all the options being traded into account and thus calculating the sentiment of the entire market. Now what does a particular value of the India VIX indicates? The value of India VIX at the time of writing this article was 19.63 which means people are thinking that over the next 30 days markets can move up or down by 5.67% [19.63 divided by square root of 12] and demanding premium as per this value. Low value of VIX indicates stability in the market while higher value indicated stress, fear and anxiety. Since, the investors are more fearful of the downside, VIX is negatively correlated to the stock market index like Nifty or Sensex which means as the market index drops the VIX value increases and vice-versa

 India VIX: Volatility Index

VIX is a measure of the implied volatility of Nifty 50 Index Option prices over the next 30 day period. It is an estimate of investor sentiment and is a helpful indicator of the amount the market is expected to "fluctuate" in the near term. Higher the implied volatility, higher the India VIX value and vice-versa.

“VIX” is a trademark of Chicago Board Options Exchange, Incorporated ("CBOE") and Standard & Poor’s has granted a license to NSE, with permission from CBOE, to use such mark in the name of the India VIX and for purposes relating to the India VIX.

How to interpret VIX?

The VIX is quoted in terms of percentage points and translates, roughly, to the expected movement in the Nifty 50 Index over the next 30-day period, on an annualized basis.For example, if the VIX is at 15, this represents an expected annual change of 15%; thus one can infer that the index option markets expect the Nifty 50 to move up or down  over the next 30-day period. That is, if, for example, the Nifty 50 is currently at 100, then the estimated 30-day change in the Nifty 50 will be within 4.3 points up or down

Relationship between Nifty and VIX

This chart has been made taking data from NSE site regarding Vix index and nifty fifty on daily basis from 2-03-09 till 8-11-2011.

This chart depicts that when volatility index was at highest Nifty was at its lowest.

NEW STOCK MARKET TERMS

CEO — Chief Embezzlement Officer.

CFO — Corporate Fraud Officer.

BULL MARKET — A random market movement causing an investor to mistake himself for a financial genius.

BEAR MARKET — A 6 to 18 month period when the kids get no allowance, the wife gets no jewellery.

VALUE INVESTING — The art of buying low and selling lower.

P/E RATIO — The percentage of investors wetting their pants as the market keeps crashing.

BROKER — What my broker has made me.

STANDARD & POOR — Your life in a nutshell.

STOCK ANALYST — Idiot who just downgraded your stock.

STOCK SPLIT — When your ex-wife and her lawyer split your assets equally between themselves.

FINANCIAL PLANNER — A guy whose phone has been disconnected.

MARKET CORRECTION —The day after you buy stocks.

CASH FLOW — The movement your money makes as it disappears down the toilet.

YAHOO — What you yell after selling a share which falls by 20% the next day.

WINDOWS — What you jump out of when you're the sucker who bought GTL one day before it crashed to 1/3 rd of its value.

INSTITUTIONAL INVESTOR —Past year investor who's now locked up in a nuthouse.

PROFIT — An archaic word no longer in use.