NIFTY Volatility Index (Part 2)

 In my previous post I had talked about the high negative correlation between the VIX and its underlying, the NIFTY. The chart on the right shows the actual movements of the NIFTY compared with the corresponding VIX moves. The period covering Mar’09 to Sep’10 marked a very rapid increase in the market (NIFTY rose from 3000 levels to 5,500). Since the VIX indicates volatility, the period at the start of this phase saw the most rapid increase in the NIFTY (in percentage terms) and that is why the VIX readings were above 40% during this time. The period from Sep’10 till date however have seen the market mostly move in a sideways direction. It started off around 5,500 in Sep’10 and is now at the 5,300 levels. Accordingly, if you look at the VIX, it has also remained mostly flat. Now, the big thought in my mind is this: we hear mostly bullish noises these days. Golden Cross; correction within an overall bullish trajectory etc. So, if the negative correlation were to hold and the NIFTY were to move up from now, it is logical to expect the fear (i.e. VIX) to come down from its current levels (~24%) t0 something like a 15% (?) or so. Since the start of this chart (chosen since that is the date range for which NSE publishes its VIX values) marked the markets coming out of a rather exceptional period in its history (global banking sector meltdown), VIX values > 40% may be really rare to come by again in the near future.  I have nevertheless plotted a dotted red line on the VIX portion of the chart which shows the median level of the VIX range. In the event that the VIX ‘reversion to the mean’ becomes a reality in the months to come then I guess we should brace ourselves for another secular fall in the NIFTY. If you take the economic events near the starting period  of this chart to be exceptional, and ignore the corresponding VIX values as outliers, then the new median will be quite close to where the VIX is today (22% – 24%) in which case there is definitely a case for it to fall down to late teens/earlier twenties. As you can guess I am rooting for a rise in the NIFTY and trying to twist my data interpretation to fit that notion!! 🙂

 The correlation factor in the above chart comes in at a high -0.83. Why such a high number? The reason could be because increased volatility (i.e. high VIX) signifies more risk. To keep their portfolios in line with their risk preferences, market participants must deleverage. Since long positions outweight short positions in the market as a whole, deleveraging entails a lot of selling and less buying (since the longs have to be shortened). The relative increase in selling causes downward pressure on stocks. The volume rise in the NIFTY puts really drives the VIX up. The NIFTY VIX is a weighted sum of puts (strikes < forward) and calls (strikes > forward) on the NIFTY. The weights are proportional to 1 / [(strike)^2]. As the NIFTY goes down, all the out of money puts become more valuable and those start having the highest weights (since the weights are the reciprocals of the strikes).

The unit of measurement of the VIX is in percentage terms. Its value essentially signifies the % expected movement of the NIFTY over the next 30 calendar days. So, for example, since the value of NIFTY VIX was 24.33% (on 29Mar’12), what the market is essentially saying is that it expects the NIFTY to move (either up or down) at a 24.33% annualized rate over the next 30 days. This implies that the market is pricing in a 24.33% /SQRT(12) = 7.02% movement at current levels over the next 30 calendar days. Which btw, is huge! In terms of confidence level, this means that the near term options on the NIFTY are being quoted with the assumption of a 68% likelihood (1 sigma) that the magnitude of NIFTY’s 30 calendar day return will be less than 7.02% (either up or down)

Taleb here points out how even seasoned market participants wrongly derive mean deviation (the 7.02% deviation as at yesterday’s close) from measures of standard deviation. My uninformed take on this is that if all are consistently making this error then that becomes the norm. Consider for instance, that a standard market data provider like Reuters or Bloomberg inadvertently distributes erroneous reference data – since both sides of the trade are using that same value, it becomes the de-facto standard and no one is out of balance.

VIX as a trading indicator: Since the VIX is a measure of dispersion and has a reversal to the mean property, all the standard technical indicators like RSI, Bollinger Bands etc can be used as identifiers for trade entry points. Since we do not have derivatives on the VIX in India yet, these technicals can give entry points into the underlying (i.e. NIFTY) by inverting the logic (buy for VIX would be a sell for NIFTY) due to the high -ive correlation between NIFTY and VIX. There have been studies which point out that the 2 period RSI on the VIX gives a very good trading signal. If the RSI (2) of the VIX >90, then buy the underlying and if RSI (2) < 30, then sell the underlying. Underlying = NIFTY in our case. I do not have any ready charting software at hand, so I will have to painstakingly generate the RSI values in a spreadsheet if I have to test and see how this really could have played out on historical data. Maybe fodder for a future post… 

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?

NIFTY EPS vs Price (update)

This is a continuation of the chart I had prepared and posted on 04May’11 here with newer data points pertaining to the intervening period in between. The trailing NIFTY P/E has indeed fallen from a level of 20.58 (04May’11) to 18.65(23Mar’12). Here’s the updated chart:

The smaller image on the right is the earlier version of this chart. There, I had done a straight line extrapolation of the most recent behaviour of the chart and predicted that the line will fall down and gradually approach an index value of 5,200 and a trailing P/E level of 18. What happened in reality (the bigger chart above) was more severe. The line moved down quite sharply (NIFTY dropped to 4,750 at one point) and rightward as well (expansion in EPS). Not that I profited too much from all of this. I am always long, so loss aversion by staying in cash/gold is my equivalent of profiting from a long/medium term, secular drop in markets. Ergo, I  havent lost much money in the interim and have ridden the dotted red line. Now, I had mentioned something called ‘cycloidal’ in my earlier post when looking at the chart – strangely enough, the line did indeed fall and is now even curling inwards, just like those cycloidal mathematical curves and/or their variants would. I don’t understand the pulse of the markets enough to figure out why this is the case but yes, we can at least look at the chart here and form our own conclusions.

TV Everywhere? Or Nowhere?

Delhi, Mumbai, Chennai and Kolkata will replace all analog telly networks with digital ones come 1Jul’12. That’s causing a nice fight to develop between Multi System Operators (MSOs) and the Direct To Home (DTH) gang. The last mile connectivity providers, i.e. the local cable operators were being squeezed in between. However necessity has forced Dish TV, a DTH company to innovate by tying up with the local cable companies. The local cable companies will serve as the distribution channel partners of Dish TV and also as sales ushers by pushing the Dish TV set-top boxes in cable households to coincide with the first phase of cable digitization which begins on 1Jul’12. All very nice and funny since Dish TV earlier used to tout itself as a business which provided an alternative to the monopoly of the local cable guys (see pic alongside)! Very confusing since now there are news that the cable companies are jamming signals of DTH transmissions in Mumbai and Delhi!

Will have to see how all of this plays out – DTH companies like Dish TV and Tata Sky claim that they have shelled out close to 20k crores towards digitisation. The current debt on Dish TV’s books is Rs. 1,200 crores already with much of it being USD denominated making it very vulnerable to INR’s depreciation. A bigger concern is that the promoters had already pledged a huge “dish” full of shares and now they’ve done more. Perhaps financial stretch will force consolidation in the infantile industry. The six private DTH platforms in India are: Dish TV, Tata Sky, Sun Direct, Reliance Digital TV, Airtel Digital TV and Videocon d2h.

Here’s the trailing 18 months chart of Dish TV. It is selling at its 52 week low but that is nothing to suggest that it may not go on to celebrate its 60/70 week low as well. The chart certainly looks bearish for now, but yes, the 50 DMA may very well begin its rise leading up to the 1Jul’12 deadline. My sense says avoid. At this point in time, I have not read and studied enough about this game to form any opinion at all. But yes, the fact that India has more than 100 million television enabled homes is very significant.

There is something seriously wrong in the Indian television and media broadcasting space. Even if the stocks are tempting on the technicals, the crazy amount of flux in the industry is just reason enough to avoid punting in them. There is a bit of a chorus coming out about Dish TV being under-valued and that it is a value play now that it is at its 52 week lows. It’s being pegged at a target of 80 in 24 months! There are also reports out there which are predicting the Indian television sector to grow at 17% compounded over the next 4 – 5 years! If that be the case then why did Rupert Murdoch’s News Corp sell its stake in Hathway after staying with its investment for more than 10 years? Zee split; Den networks has packed its den with debt; media companies like NDTV, TV Today, TV18 etc are moribund as ever; Sun TV got tainted by corrupting sun spots; ENIL’s mirchi is anything but hot on the bourses; and so on….

Lets Buy Oil, Not Gold

What is the difference between the professions of the Shahrukh Khan version of Don vs. the earlier one essayed by Amitabh Bachchan? The original Don was a gold smuggler while the new one pushes drugs – quite a subtle generational shift this and very much attributable to the lifting of the import duties on gold in 1992. The yellow metal had flowed in freely once the shackles were removed. The differential between the Indian price of gold vs. the UAE one reduced to a level so as to make the risk weighted returns of smuggling very low indeed. Ergo, the villians in Hindi films underwent an apt metamorphosis. Even ertswhile smugglers gave up their shady coves and wharfs and took to politics. But the smuggling never really died down – it continues to this day and the recent budgetary proposal to increase the basic customs duty on gold imported into India will certainly do its bit to not only revive this old cottage industry but also bring the old Bollywood villian out of his holster. Even godmen have dipped their toe in the pool – Swami Nityanand’s name has been doing the rounds it is said.

It’s a good thought, according to what I have read and understood provided that the authorities (read customs, BSF, RAW, etc) can lift up their game to apprehend all worth appprehending – it could turn out to be good for the economy in the longer run. They are saying that China looks all set to overtake India as the world’s largest consumer of gold – if the logic of the customs duty hike is bona fide, then this is one race which we’d be better off letting China win. As such China beats India nearly everywhere anyways. The chart alongside (via World Gold Council) hints at this. From the country’s viewpoint, gold holdings, are no different from foreign exchange reserves really – despite the fact that a huge chunk of India’s gold is in private hands and therefore cannot be mobilised easily if required to serve for national duty. Which is why the move to curb gold consumption (and therefore gold imports) by raising customs duty makes sense. We consumed 1,000 tonnes of the yellow metal in 2010 and another 933 tonnes of it during the next year! While it is clear that the current risk aversion trade and low tariffs have been responsible for this influx, the taps have been flowing all through the 70s and 80s – via the surreptitious route. Today, gold is now officially the most smuggled item to India having pipped television sets to the post. Which is why the government came out with a couple of gold mobilization drives to shore up the foreign exchange reserves. If this is the method that the planners of the economy are betting on to control the trade deficit, then I am guessing that sometime in the future we will see another issue of these gold swapped bonds/gold mop-up drives. Lets see. Remember, RBI had bought 200 tonnes of gold from the IMF sometime in late 2009. I guess they won’t be needing to do that anymore. The notion that the national stock of gold can indeed be considered as a proxy reserve of foreign exchange currency reserves is buttressed by the fact that India recently purchased oil from Iran using gold. Did you know that nearly a third of our current trade deficit is due to our purchases of gold.

The government, via two customs duty hikes in quick succession, is hoping to provide an external stimulus that helps the economy to break out of the current gold – inflationary cycle. The customs duty hike works in the import stage which is circled in yellow in the picture alongside.

NIFTY Golden Cross

Further to the last post, here’s the trailing 18m NIFTY chart which shows that new golden cross that has just happened. The question really is – how long will the 50 DMA stay above the 200 DMA line?

NIFTY’s Crossovers

A golden cross happens when a smaller daily moving average intersects and moves above a larger daily moving average, commonly the 50 DMA squigglier line cutting above the meandering 200 DMA line. They say that golden crosses mark the transition into the bull market. Well, NIFTY sure seems to be plotting and planning a golden cross and I guess the next few days will make it clear. The budget is around the corner, so it may very well be the case of Mr. Market holding its breath, crossing his fingers and hoping that nothing stupid, unexpected or untoward happens – all the populous evil having already been factored into the price. If the day passes over (RBI is widely expected to sit out of this party having done its bit in terms of the CRR cut) then its likely that the market resumes its upward journey with the 50 DMA pulling away from the crossover point.

So, I pulled up data on the NIFTY from 2000 and charted the various crossovers between the 50 DMA and the 200 DMA. The green columns indicate days where 50 DMA > 200 DMA while the red ones are for days where 200 DMA > 50 DMA. The gray mountain range is the NIFTY during this entire period (17Jan02 to date) rebased to zero at the starting date of this chart (i.e. 17Jan02). The reason the chart starts from 17Jan02 is because I have NIFTY data from start of 200 and from that date it took upto 17Jan02 for the first golden cross to appear (if the index values before 2000 are ignored). The point is that up till now the proportion of days that the 200 DMA is greater than the 50 DMA (bearish climate) has been quite low – as you can infer visually from the chart.

Gold and Monetary Thoughts

The latest RBI working paper invites public comments on the topic “Gold Prices and Financial Stability in India“. The paper notes the recent sharp rise in international old prices; examines inter-linkages between desi and international gold prices and finally brings out the emperical observation that the implication of a correction in gold prices on the Indian financial markets is likely to be muted. I also picked up this interesting chart from the paper which compares the real and nominal prices of gold right from 1971. Interesting to note that the precious metal has never “really” breached the USD800/ounce mark, though it came very close to challenging that limit, during 1979/80 and 2011. The nominal price high has been ~$1,900 which came in Nov’11.

Shiploads worth of unaccounted wealth has always kept the demand for gold very high in India, making even someone like John Maynard Keynes liken our desi fixation for it as a ‘ruinous love of a barbaric relic‘. The paper notes this pre-historic Indian yearing for gold but then it makes a point which I don’t quite follow: the authors (of the paper) measure some important macro-economic parameters and restate them in gold terms; and observe that the value of these indicators has actually fallen in gold terms and therefore they conclude that gold must not be in ‘bubble territory’. Duh. Anyways, the paper also notes the fact that the really devastating asset bubbles are the ones that take the banking sector down with it – the dot-com bust has certainly caused lesser damage than the sub-prime crisis. I read up on some literature on the internet on this notion of complicity of the banking sector in global recessions and noted the events that have lead us to today’s line of monetary thinking:

By the 1830s, in England, it was generally believed that the mere legal requirement that the liabilities of the banking system (i.e. public deposits) be convertible to gold on demand was not sufficient to prevent various economic crises. So, in 1844 they introduced the Bank Charter Act which established a currency board – based on gold – to eliminate the banking system’s ability to create fluctuations in money supply. Between prices and money supply, it was firmly believed that prices were the effect and the supply of money was the cause. However, economic crises continued to persist in England in 1847, 1853 and 1865. The prime reason cited for these crises was that the framers of economic policy had not paid much attention to the role of bank deposits in the monetary system.

So, as a result of this, by the 1870s, monetary thinking brought in the concept of the Bank of England being the ‘lender of last resort’ . Gold convertibility was never in question and though financial crises did occur in England from time to time, none involved bank failures. The British experience was well known to observers in the US, where crises involving bank failures were a regular feature of the financial landscape until 1914 – this provided an important impetus for the founding of the Federal Reserve System and there onwards to the following 4 phases:

1. Classical Gold Standard (1880 – 1914): Governments accorded the highest priority to maintaining fixed prices of their currencies in terms of gold.

2. Interwar Gold Exchange Standard (1925 – 39): The techniques developed during the era of convertibility under the gold standard proved insufficient when the need of the hour was to ensure and provide domestic macro stability – ultimately resulting in the Great Depression. Countries cared little about their ‘neighbours’ and freely debased their currencies in order to make exports more attractive in order to grab a slice of the post war economy rebuilding opportunities.

3. The Bretton Woods International Monetary System (1944 – 71): Post WWII, ex Allied nations favoured a regulated system of fixed exchage rates, indirectly disciplined by the USD, which in turn was pegged to gold. All agreed on the need for tight controls. ‘Beggar thy neighbour’ no more. 

4. Managed Float (current): The great inflation of the 70s made policy makers re-emphasize the goal of low inflation and to commit themselves to convertibility-rule like behaviour. USA broke away from the Bretton Wood fetters and freed up the USD from the gold overhang. USD thus became a fully fiat currency.

So the cycle continues and gold (in real terms) has again risen to levels that it earlier saw during the runaway inflation levels of the 70s. Gold has always been central to monetary thinking – even in its divorce from monetary planning in recent times, the need for gold is as important as before – by proxy. When a currency becomes fiat – it derives its value from it’s issuer country’s regulations and policies. The modern economic policy of low inflation and mindless credit expansion has all but effectively debased these fiat currencies (USD and EURO). Therefore, the growing interest (and price increase) in gold under the hope that the current regime of managed float will end and we will move back to the era of tighter monetary regulations backed by gold. According to me, if that happens then fluctuations in the price of gold will most certainly impact prices and financial stability. The probability of occurrence of that happening anytime soon is incomprehensible to me. You need an expert to opine on that – but I’d just say that the world revolves around the USD – fiat or not.

The banking sector has very much been in the eye of the storm during the current economic crisis and therefore no one would play blind on a bet that gold may not breach the $900 psychological mark…

REC Tax Free Bonds

 I just applied for 1L worth of tax free bonds from the Rural Electrification Corp (REC) whose IPO opened today. This appears to be the last opportunity this year to buy tax free bonds and the application window is open till 12Mar (very small really). Unless you have pigged up heavily on fixed income, this issue should warrant more than a cursory glance by you. Here are the salient points from the prospectus (click here):

  • Ratings: “CRISIL AAA/Stable”, “CARE AAA” , “FITCH AAA(ind)” and “[ICRA]AAA”. So from that perspective looks to carry a low credit risk
  • No one’s underwriting the issue. No one wanted to or did the AAA ratings make REC say no to middlemen?
  • Usual 3 categories but NRIs absent from the scope. Sad. This is apparently to ensure that the allotment etc gets done within this FY and some folks say that involving our foreign bhais will slow down things. In any case the previous issues by NHAI, HUDCO etc took more than a month to get listed.
  • Interest of 8.13% for 10 yr and 8.32% for 15 yr bond for Category III (retail rats). 750 crores (25%) of the issue is reserved for Category III which means if more than 75,000 individual applications come in at cut-off, then the allocation game of dice will play out. Allotment will be made on a first come first served basis. In case it gets oversubscribed (which I assume it should) then if your application reached the bankers one day prior to the date when oversubscription occurred, you’d get the FCFS treatment else you’d get proportionate to your application amount. So it pays to apply early. The recent NHAI tax free issue was oversubscribed by 2.5 times.
  • The NHAI tax free bond, while it took its sweet time to list, jumped up immediately when it listed on 7/8 of Feb’12. It went up some 2 – 3% during listing time – which means that tax-free bonds are best bought during their IPOs and not from the secondary markets.
  • The 09.15 G-Sec maturing on 2024 (12 years to go) is trading at yield spreads of 8.27% – 8.28%. (
  • Interest will be payable yearly on 1Jul. Would’ve been nice for Category III to get a cumulative interest option. Even then, 10 yr bank deposits offer less than 10% today and when you bake in the tax benefit (if you are in the highest tax bracket, these bonds give you a return of ~11.5% or so.
  • While you can apply in lots of 5 bonds (fv 1000/- each) you can sell one bond at a time, if you wish. Given heavy institutional interest for the 10 year paper, liquidity and therefore demand is likely to be high on that and therefore price of the bond on the secondary market (will list & trade on BSE) should be higher. If RBI does start dunking down interest rates towards the latter part of the year, then the price will canter up more. But capital gains tax will apply.  

It was good that IRFC’s (which is the financing arm of Indian Railways) budgeting went a bit awry (their plan size for FY11/12 was cut by 16%) and they could not use up their quota of tax-free bonds. That slack got transferred to REC instead of the Government allowing railways to roll over its unutilized portion to next FY. The Government had allowed INR 30,000 crores to be raised by infra sector PSUs during the current FY via the tax free bonds route. Assuming an interest payout of 8% this translates to a servicing cost of 2,400 crores. Assuming a low tax rate of 20%, this translates to INR 480 crores of income forgone by the Government which means a margin give up of 1.6%. But I guess that’s small change if you get INR 300 bn of capital in a year to fund infra building…

This is surely a good thing – I hope that the FM announces an even higher quota for the next FY.

Confirmation Next Week?

The NIFTY chart is poised at an interesting point as at this weekend. The 50 EMA is about to deliver a right uppercut to the 200EMA…hopefully. If it does, then I guess the bull market will be really, really confirmed. Budget dithering and the slipperiness due to oil may keep the 200EMA above the 50EMA though…

Lupin’s about to break out, Gitanjali and Godrej Industries are doing awesome; so is my relatively recent pick – Jubilant Foodworks. I’m long a NIFTY ETF as well…looks like the smile may just about be coming back…fingers X’d

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