Most of the option traders familiar with the term India VIX, but don’t know about the function of the volatility index. Here we can simplify the calculation for a better understanding of our fincareplan readers.
We have a basic understanding of derivatives markets in our previous article, let’s move to advanced levels in options trading. Before going to the topic, we will explain what is India VIX?
India VIX is a volatility index, that value will be computed from the nifty index option premium. People are commenting, the market is highly volatile today, how they are saying, what is volatility how it will be measured. Try to understand the basic terms one by one.
As per the national stock exchange of India, volatility is often described as the “rate and magnitude of changes in prices and in finance often referred to as risk. In simple terms volatility referred to as the uncertainty about the price changes in a security or index value. The higher the volatility, the higher the risk.
The volatility index is a measure of market volatility over the near term. Professional options traders, take the position based on the VIX movement, what they are predicting from the volatility index.
Generally, during the time of volatility, the market moves higher low to higher high or lower high to lower low and the volatility index keeps on rising. If the volatility index is declined, the volatility of the index also less.
Remember one thing, the volatility index is different from a price index like NIFTY and BANK NIFTY. The price index is calculated using the price movements of underlying stocks.
The volatility index is calculated using the order book of the underlying index options and is denoted as an annualized percentage.
The Chicago board of options exchange was the first to introduce the volatility index for the U.S market index S&P 100 in 1993.
There was a change in the calculation in 2003 and revised methodology was adopted in S&P 500 index option. Since its inception, it has one of important for derivative traders, based on the volatility, traders set up their trade-in near month contract.
India VIX Index:
It is a volatility index computed by the National Stock Exchange (NSE) based on the order book of NIFTY options. India VIX indicates the trader’s perception of the
India VIX is calculated based on the Black Scholes Model which is used to price the option premium. The model uses different kinds of key variables to arrive at the fair price of an option contract.
- Strike price
- Current market price
- Time to expiry
- Risk-free rate
- Market volatility
We don’t get into the complex formula of the Black Scholes method to calculate the India VIX but try to simplify the interpretation of the volatility index.
For example, India VIX was trading at 20.30, what it means? It represents an expected annual change of 20% in the index price movement for the next month.
Simply it’s defined the market range between + 20% and – 20% from the current spot price of the nifty. Just calculate the price range of the next year, if nifty was traded around 13000. It clearly indicates that for the next one year the nifty range will be 10400 to 15600.
If you want to know about the monthly range, simply use the below formulae
Monthly range in index = VIX / √ 12
Here, we simply assume the 30 calendar days for 12 months, try to calculate the monthly range in nifty that will be 20.30/3.46 = 5.86 % almost 750 points deviation expected in next one month.
It will helpful for the option writers to identify the index range to short the out of the money option to collect the premium. For option sellers theta (time decay) is a friend and volatility is an enemy that’s why they are very much cautious about the volatility index.
MOVEMENT OF INDIA VIX IN COVID 2020 MARKET CRASH:
The above picture shows a clear understanding of the India VIX movement. For your understanding in March 2020, India VIX touches the high of 85.34, and nifty was touched the bottom of 7500.
In November 2020 the scenario was changed VIX was bottom of the table and nifty was trading around 13000. These two indexes were inversely proportional to each other.
- Options traders as well as investors will get a fair idea about the India VIX and understand the negative correlation between the index and volatility index.
- The market will capture the number of factors, based on that underlying stock price will vary. Don’t blindly follow the VIX, it’s also one of the numerical factors to identify the market movement.