The volatility index is a measure of the equity market’s expectation of volatility over the next 30 days. Markets rise or fall steeply during volatile periods. The volatility index rises at such times.
However, it may or may not decline when the market volatility subsides as that depends upon the market participants’ future expectations of its movements.
The index is calculated as annualised volatility and is denoted in percentage. For instance, Wednesday’s index closed at 20.82 per cent.
How is it calculated?
The National Stock Exchange’s (NSE) VIX tracks volatility, based on the index option prices of NSE’s benchmark index NIFTY on a real-time basis since July last year. It is computed using the best bid and asks quotes of the out-of-the-money near and mid-month NIFTY option contracts, which are traded on the futures and options (F&O) segment of NSE.
Several other factors like the weightage, time to expiry of the selected options contracts and so on are considered to calculate the index.
Why should an investor pay attention to the index?
The index signifies the risk associated with the market. The higher the volatility index, the greater the perceived risk associated with investing in the market.
The volatility index is a strategy tool used by option traders having large positions. While its movement should not matter for long-term investors, others could use it to hedge their positions in the derivatives market.
Investors use it to decide whether to buy or sell an option since the higher the implied volatility, the higher the option premium. Typically, when the implied volatility is low, the premium is less and the investor would buy an option accordingly.
Investors, who want to hedge when the volatility is low but the market is up, should buy a put option in the derivatives segment. If both the market and the volatility index are down, the investor should buy a call option to hedge his cash, if at all. If they are both high, then the investor could sell a call option to hedge his portfolio. But this kind of hedging would be partial since his income would be limited to the premium received.
NSE plans to make its India VIX index available for derivatives trading after it gets regulatory approvals from the Securities and Exchange Board of India (Sebi). This would allow investors to use the product to hedge their portfolios against the risk arising out of volatility and traders can bet on the volatility movement on the index.
