Gauging Market Trends With VIX

As an investor, market indicators can be your best friend but only if you know how to read them accurately. Karan Bhojwani explores the importance of tracking the volatility index VIX and explains in detail how best to interpret what is commonly referred to as the ‘fear gauge’

Participating in the stock market is all about speculating or estimating the future price movement of the underlying asset. Different investors and traders use different methods, techniques and systems to estimate the future price movement of stocks and indices. There are various popular indicators that are used by market experts and investors alike such as oscillators, RSI, moving averages, trend-lines, etc. to understand where the market is headed. Some bank on the 200 days’ moving average while some use the ‘put and call’ ratio while some use the Indian VIX to gauge market sentiments.

Says Sandip Parbat, who has been trading in equity for over a decade, “I am a big fan of put and call ratio and use the moving averages regularly before deciding on which stocks to enter and exit. However, I have never used VIX for my trading decisions, maybe because I never understood it completely. I heard one of the analysts commenting on VIX and stating that it has increased by some 30 odd per cent and that is considered significant for the markets. I think I will start tracking VIX more regularly now but not before I get a better grasp over it. Half knowledge is dangerous when it comes to the equity markets.” It will not be incorrect to say that several traders ignore the VIX reading while basing their trading decisions. What is VIX after all and how best can an investor interpret the VIX readings?

"My interest is in the future – I am going to spend the rest of my life there: C F Kettering American investor 

Defining Volatility

Volatility measures the frequency and magnitude of price movements, both up and downthat a financial instrument experiences over a certain period of time. The more dramatic the price swings in that instrument, the higher the level of volatility. Equity markets is about greed and fear with greed dominating the markets at times while fear at times being more dominant. It is essential for any trader to gauge the larger market moods before investing or trading in the markets. Here is where the Indian VIX comes into the picture. It is a fear gauge and is widely used by experts to ascertain the market moods before making investment or trading decisions. India VIX measures the degree of volatility or fluctuations that active traders expect in the Nifty 50 over the next 30 days.

Originally, it was the Chicago Board Options Exchange (CBOE) which came up with the term VIX in 1993. NSE kicked off India VIX after taking relevant permissions from CBOE. To understand what VIX is and how to interpret it, it is useful to first understand how it is calculated. VIX uses inputs from Black Scholes Model which is used to price options contracts. There are five key variables used in this model to find a fair price of the option contract, namely, the strike price, time to expiry, current market price of the underlying asset, the risk-free rate and the volatility. VIX is derived by backward working from buy-sell prices of Nifty options contracts and calculating the expected volatility, also known as implied volatility. 

"It is said that the present is pregnant with the future: Francois-Marie Arouet (Voltaire) French historian and writer. 

Reading the VIX

If Nifty is trading at 11,000 and VIX index is currently at 26, it can be interpreted as a probable annual variation of 26 per cent in the next 30 days. It is important to remember that the variation is annualised and the monthly variation comes close to 2 per cent. This essentially means that Nifty can move in either direction by 220 points. 

In other words, VIX is a measure of expected volatility and explains the level of fear or complacency in the market. The reason why VIX is important for traders and investors alike is that it is a good indicator of whether the participants in markets are feeling fearful or complacent about the near future. The other way to interpret the VIX reading is that it represents the expected annualised change in the Nifty 50 index over the next 30 days. For example if the VIX reading is 12, it means that for the next one month investors expect the Nifty to move by 12 per cent (annualised) in either direction. The VIX reading for March 6 was 26, indicating that investors expect the Nifty to move by 26 per cent (annualised) in either direction.

This can be considered a huge movement considering the fact that the VIX reading as on February 20 was just 10.16. Thus, the expected volatility in markets has jumped more than two-fold in less than a month. While basing trading decisions using VIX, one must also remember the extreme levels recorded by VIX. For example, on May 19, 2009, VIX reached 57.10, the highest recorded levels while the lowest levels were seen in June 2017 when VIX touched 8.75. Also, the 52-week range can be useful to interpret the VIX levels. The VIX has been trading in the range of 28.66 to 10.53 levels in the past 52 weeks. As VIX has been trading at 26 odd levels in the first week of March we can say that the VIX levels seen are close to the top end of the range seen over the past 52 weeks.

VIX Interpretations

At the outset let us be clear that the VIX is negatively correlated to the Nifty i.e. VIX tends to drop when Nifty goes up and vice versa. The high levels in VIX (higher than 20) suggests that one can expect large movements in Nifty. Levels below 15 in VIX can be considered low levels. As the value of Nifty Futures is derived from the Nifty (Underlying), similarly we have an India VIX Futures which derives its value from VIX (Underlying). Investors can hedge their equity portfolio by buying India VIX Futures in case they intend to hedge their equity portfolio. Investors can also shorten the India VIX Futures in case the volatility has peaked. One of the best ways of profiting from India VIX Futures is by going long at lower levels ahead of a major event that promises to make markets volatile.

"To expect the unexpected shows a thoroughly modern intellect: Oscar Wilde, Irish poet and playwright

Conclusion

Sentiment indicator like any other market indicator can be an investor’s friend only if the interpretation is correct of the indicator. The trick to beat markets is to understand VIX reading accurately and then adjust your trades and positions accordingly. Investors and traders should realise that one of the major problems with the sentiment indicators such as VIX is that the extreme readings can stay where they are for a long time – running into months – and hence can be frustrating for traders. Aggressive traders can profit by trading in volatility while portfolio investors can use VIX as a hedging tool against volatility. Whatever is the purpose – profiting from volatility or hedging volatility – VIX can be your best friend.

India VIX and Nifty Correlation 

Prashant Shah
CMT, CFTe, MFTA,MSTA Founder - Definedge Solutions 

VIX is a real-time volatility index which reflects the volatility expectation of the market participants in the next 30 calendar days. VIX is calculated based on the weighted averages of the implied volatility of the Nifty index options. Implied volatility is the expected volatility in the market as implied by the options activity of the market participants. For most part, VIX is inversely correlated to the market and acts a barometer of fear or uncertainty in the market which leads to higher implied volatility as market participants rush to buy the protection of ‘put’ options to hedge their portfolios.

As shown in the figure, VIX has a tendency to rise sharply when the market is bearish due to an unfavourable event or news flow such as announcement of LTCG Tax after one year during the Union Budget in early 2018, NBFC crisis in late 2018 or due to the current worldwide corona virus scare. In most cases, a sharp spike in the VIX can be used to determine if the market selling is overdone or if the market is making a bottom. VIX usually subsides or remain stable when the market rallies or remain sideways. When VIX is at extremely low levels in a persistent manner, it can indicate extreme bullishness in the market and can point toward a potential turning of the market to the downside. 

But there are exceptions when VIX is not inversely correlated to market movement in events such as the 2019 general elections when VIX rose along with the market as there was a positive expectation that the incumbent government would return with a stable majority but with some uncertainty. Volatility, just like most other things in life, is cyclical. It contracts and expands. VIX can be used by traders as an indicator to do dynamic position sizing and risk management.

Traders can use lower position sizing when volatility is high and normal position sizing when VIX is in a stable range or lower. The stable range can be determined by the traders using a five-day or ten-day average true range (ATR) of the VIX. To summarise, VIX is important to understand the volatility and its relationship with the market from both an analytical and risk management point of view.

A good understanding of such a relationship will help investors and traders in taking timely decisions to either buy protection to hedge portfolios or to reduce the position size to control the risk.