NIFTY Volatility Index (Part 1)

The volatility index measures the market’s expectation of near term volatility. A low value of VIX accordingly implies that the market believes that prices will fluctuate very less from its current levels. This would typically be associated with low volumes – see chart on right, it shows a correlation of +0.72 between NIFTY volumes and VIX. Now, correlation is obviously not causality, and accordingly a lack of trading volumes does not by itself cause depressed VIX values. On the other hand, VIX is negatively correlated to the market, a high value (of the VIX) indicating loads of nervousness (option writers demanding high premiums due to the uncertainty in prevailing underlying prices) while a low VIX value signifying low levels of nervousness and higher confidence in the sustenance of the market levels (options writers will not find takers if they charge more for the options they write, so the premiums will be lower in a market with low volatility). A similar conjecture can be made by looking at the put/call ratio as well – low indicating range-bound or slowly rising market in the near term.

One point is important to note re the inverse correlation with the market. The table on the right shows average correlations for different time periods of observation. I downloaded VIX values from 2Mar09 till date and correlated them with corresponding NIFTY values in windows of 5, 20, 40, 60, 90… trading sessions. The table on the right shows the average correlations I got. Assumming 5 x 52 ~ 250 trading sessions in a year, this points to an average correlation of -0.63 to -0.64 over a year. In the second part of my post on VIX, I’ll try to study the actual movements of VIX over the past years and any trading opportunities that may have come about in the past.

Click here to get a white paper explaining the calculation methodology. A summary is here. Since herd behaviour like greed and fear can be deduced from VIX values, it is logical to assume that greed will chase fear and vice versa. VIX therefore has a mean reversal property making it a very useful tool for short term traders. Given the high volatility in Indian stock markets, VIX was long overdue. The CBOE (Chicago Board Options Exchange) had launched its VIX as far back as 1993. It finally came to us in April 2008 when NSE launched it, expectedly basing it on the option prices of the stocks that make up the NIFTY. There is not much noise about the VIX in mainstream financial media in India yet. Is it because it is relatively new on the scene? Or maybe it might be a bit too nerdy for most people to understand. But so are options. How many of the people who trade options really understand the math behind option prices?