What is India VIX?

The India VIX index is a volatility index that is a broad measure of the market's expectation of volatility over the near term. It is calculated from the prevailing index option prices of the Nifty and is usually denoted as a percentage rather than an absolute value. This is very different from a price index such as the Nifty that is computed based on the movements in price of the underlying constituent stocks. The higher the index value the more volatility this is expected by the marke ts in the short term.

The National Stock Exchange (NSE) started trading of futures contracts based on the Indian VIX index from 26th February, 2014. This is a very welcome and long overdue move as it would provide another effective tool to traders to hedge and protect their positions from the short term volatility in the markets. To get a better understanding of how these contracts could be used in protecting portfolios it is necessary to analyze and understand how the VIX index works.

The India VIX index is a volatility index that is a broad measure of the market’s expectation of volatility over the near term. It is calculated from the prevailing index option prices of the Nifty and is usually denoted as a percentage rather than an absolute value. This is very different from a price index such as the Nifty that is computed based on the movements in price of the underlying constituent stocks. The higher the index value the more volatility this is expected by the markets in the short term.

The VIX index is computed using the best bid and ask quotes of the out-of-the-money near and mid-month Nifty option contracts which are traded in the F&O segment of the NSE. To put it simply, the option contracts that are traded with the Nifty as the underlying allow us to calculate the VIX value at any given point of time. To better understand this mechanism let’s look at the near month option contracts for the Nifty.

What is India Vix Meaning?

The India Volatility Index (India VIX) is a measure of market volatility calculated by NSE using NIFTY options' order book. In the context of the India VIX meaning, unlike price indices such as NIFTY, it gauges anticipated volatility. Derived from bid-ask quotes of near and next-month NIFTY options, India VIX signifies investors' expectations of market volatility in the next 30 days. A higher India VIX indicates greater predicted volatility, reflecting the market's anticipation of sharp movements. It's an annualized percentage derived from underlying index options, not influenced by equity price movements.

Nifty Option Chain - February 2014

The India VIX, measuring market volatility, involves four crucial elements in its calculation. Time to expiry is minutely calculated for precision, using minutes instead of days. The risk-free interest rate considers the relevant tenure rate (30 to 90 days) for NIFTY options, influencing the calculation. The forward index level identifies out-of-money options, determining the at-the-money strike for selecting option contracts. This level is pivotal, reflecting the most recent NIFTY futures contract price for the given expiry.

Finally, bid-ask prices for options contracts, specifically the ATM strike, are slightly lower than the forward index level and contribute to India VIX computation. Each element plays a distinct role, collectively shaping the anticipated market volatility over the next 30 days.

Source: NSE

As of today (11th Feb, 2014) the options contracts that we would consider in our calculations would be a mixture of the contracts expiring in the immediate month (27th Feb) and those expiring next month (27th March). Displayed above are the contracts for February sorted by the varying strike prices with Calls displayed on the left and Puts on the right hand side. As mentioned above we would only consider out-of-the-money options only; with the Nifty currently trading at 6070 the out-of-the-money options for each are highlighted in the respective red boxes.

Now that we understand which contracts will be chosen let’s take a step back and try and understand how exactly options pricing works. Most option valuation models used today work off some form of the Black-Scholes model that was developed as a theoretical tool for the valuation of options. Without getting into the details or the complicated mathematics behind the model lets understand that option prices are broadly determined in part by the following variables-

• Current Underlying/IndexPrice
• Options Strike Price
• Time Until Expiration
• Implied Volatility

Risk-Free Interest Rates

An option's premium or price comprises only two main components;1) its intrinsic value and 2) its time value. The intrinsic value is nothing but the difference between the price of the underlyingand the strike price of the option. Any extra premium that is in excess of the option's intrinsic value is referred to as the time value of the option. The time value is itself influenced by various other factors, such as implied volatility, time until expiration, current underlying price, strike price and interest rates. The most important of these is implied volatility which is what we will focus on here as the VIX index is derived from this value.

Volatility is essentially a measure of the rate and magnitude of the change of prices (up or down) of the underlying. A high rate of volatility means that prices of the underlying are expected to fluctuate widely while a low rate implies steadiness in the prices. Implied Volatility is essentially that rate of volatility which if entered into an option pricing model (like Black-Scholes) will give us the current market price of the option. Let me explain this further; if we use an option pricing model to find the theoretical price of an option we will often find that it is different from the prevailing market prices, the reason for this is a higher/lower volatility being expected by the market. This in essence is implied volatility; the rate of volatility that is implied by the price of an option in the market. Let’s take an example to make this clearer; this January when Infosys reported its Q3FY14 results the stock jumped up more than 3% but the value of its call options either fell or gained only slightly. All other things being equal we would have expected a 30-35% jump in the prices but this didn’t materialize because of implied volatility. In previous quarters the stock had jumped more than 5-15% immediately after its results every single time; as a result the market was pricing in a similar move this time as well and the option prices were much higher than the theoretical prices due to a high level of implied volatility assumed in their pricing. After the results came out the volatility levels crashed and this had an immediate effect on the prevailing option prices limiting any gains.

Implied volatility levels give us an idea of the risk that is being priced in by the market at any given point of time. As a results if we analyze all the different options that are traded on the Nifty we can get a composite value for volatility that is being assumed on average by the market for the entire index. This composite value is calculated on a daily basis and a collection of these values gives us the VIX index. Looking at the VIX index we can immediately decipher how much risk is being priced in by the market; this is why the VIX index is also commonly referred to as the ‘fear-gauge’ of the market as it allows us to quantify the uncertainty, fear or even complacency/greedprevailing in the market at any given point of time.

Nifty Index & VIX Index

Source: NSE

The Nifty and the VIX index are generally negatively correlated and move in opposite directions to each other expect in certain special circumstances. For example in the above chart we find that during March-June 2009 both indices were moving up; the reason for this is that the general election results were coming out in May, 2009; a special and rare event. The market was expecting favorable or decisive results, hence the move up in the index; yet at the same time there was significant uncertainty surrounding the entire event which led to a spike in the VIX index as well. The market jumped ~17% on the day results came out and the UPA got close to a majority verdict. Yet the VIX index continued to remain elevated as the market was still unsure if a stable government would be formed. Finally once the UPA was sworn in the VIX index crashed from its 50-55 levels to 15-20 over the next six months accompanied by a strong market rally.

The Nifty & VIX are negatively correlated with a -.81 correlation in the above period. This implies that when the market moves up there is anopposite movement in the VIX 4/5 times. This can be a valuable forecasting and hedging tool for traders especially with the launch of VIX futures. In most of the major declines in the market since 2009 the VIX index has almost always moved in the opposite direction each and every single time. So as a trader if we are expecting short term volatility to increase due to any unforeseen or unpredictable event then we would go long on VIX futures to protect or hedge our stock portfolio/Nifty futures position. Any losses in our portfolio would be compensated by an increase in the value of our VIX futures contract if both of them were to be perfectly hedged against each other.

Similarly the VIX index can also be used as a forecasting tool and to time entry/exits from the market. In the above figure whenever the market has hit levels between13-15 it has more often than not been followed by a sell off. Such low levels on the VIX indicate complacency in the market and it is during such times that traders should be careful or possibly even at booking some profits. Similarly whenever the VIX index has hit 30-35 sort of levels it has always been followed by a rally in stocks. Such high levels indicate the high pessimism or panic in the market and possibly the end of a correction in prices.

With elections happening later this year the volatility in the market is expected to definitely go up and the NSE has chosen a very apt and opportune time to launch futures trading on the VIX.

Importance of India VIX Index

The India VIX is a crucial gauge reflecting investor sentiment and risk perception. A high India VIX suggests an expectation of substantial market shifts, signaling a volatile period where investors anticipate significant price fluctuations. Conversely, a low India VIX indicates a market anticipating minimal changes, portraying a period of relative stability where investors foresee limited volatility. In essence, the India VIX serves as an important indicator of the perceived risk and helps market participants make informed decisions based on the expected level of market turbulence.

How to use India VIX for Trading

While talking about India VIX usage, it is important to note that it serves various purposes in the market. For equity traders, it's a reliable risk indicator, helping intraday and short-term traders adjust their strategies based on increasing or decreasing market volatility. It's particularly valuable for managing stop losses during potential spikes in volatility. Long-term investors, although less affected by short-term fluctuations, find the VIX useful as a signal for risk management.

Institutional investors may adjust hedges when the VIX suggests rising volatility. Options traders leverage VIX insights to make decisions—increased volatility makes options more attractive for buyers. Additionally, the VIX can be a tool for trading volatility directly, and its correlation with index movements aids index trading and guides portfolio managers in adjusting stock exposures based on VIX peaks and troughs.

What are VIX Futures Contract Features?

• Instrument Name- FUTIVX
• Symbol of the Underlying- INDIA VIX
• Expiry date- Every Tuesday of the Week. In case Tuesday is a trading holiday, the previous trading day shall be the expiry/last trading day. All contracts shall expire at the normal market closing time on the expiry day or such other time as decided by Exchange.
• Contract cycle- Weekly - 3 serial contracts. New futures contracts shall be introduced for every week, after the expiry of the relevant previous week’s contracts.
• Spread contracts- Near-Mid, Near-Far & Mid-Far
• Contract Value- Minimum Rs. 10 lakhs at the time of introduction
• Lot size- Shall be informed through a separate circular
• Quotation Price- India VIX Index * 100
• Price steps for contracts- Re.0.25
• Quantity Freeze- Shall be informed through a separate circular
• Base Price- Daily Settlement Price of the contract.
• Daily closing price- Volume Weighted Average Futures Price of trades in the last half an hour or theoretical price.
• Price ranges of contracts- Operating range of 10% of the base price
• Normal Trading Hours- Monday to Friday 9:15 A.M. to 03:30 P.M.