Volatility Index: What is it and its Impact on Equity Market?
A lot of traders and investors, no matter how experienced they may be, fear the market at times, and for a very good reason too! The market is known to fluctuate in a volatile manner, leaving many participants with heavy losses, at least once in a while.
However, the good news is that the Volatility Index or India VIX, as it is known here, can help investors and traders understand the volatility in the equity markets.
Based on the VIX, market participants understand the risk in the market and plan their trades, investments, and strategies accordingly so that they can steer clear of as many losses as possible.
To get a quick background, the VIX was introduced by the Chicago Board, and the India VIX or Nifty VIX has been adapted from that concept. Since the VIX is indicative of the fear prevailing in the market, market crashes are either followed by a sharp spike on the VIX or vice versa.
Calculation of the Volatility Index
When calculating the VIX, you will also need to calculate the value of an option which is based on the following factors:
- Stock price
- Interest rates
- Expiry Date
- Strike Price
The volatility is one of the most important factors that measure the risk of an option. The volatility is high for options values because buyers of options have the right to buy or sell a stock but are not obligated to do so. The price increase can benefit you if the volatility is positive, and even if it is negative, the losses won’t go beyond the limit of the paid premium.
Now that we know how options are impacted by the VIX, let’s see how the VIX impacts the equity markets:
Impact of the VIX on the Equity Markets
Among all the market participants, the VIX is considered to be a good means to gauge the perceived risk in the market. When the volatility index moves up sharply, it simply means that the volatility expectations of the participants are also rising on the same scale.
Hence, the option values also move up since the puts and the calls also go up along with the expectation of volatility. If a trader considers a strategy at such a time, they may want to opt for long strangles on the Nifty.
Also Read about Short Straddle
Since the Volatility Index is indicative of the perception of fear in the market, this negative covariation forms a link between the India VIX and the Nifty.
The correlation between the Volatility Index and the Nifty levels has always been negative but consistent. If the historical correlation is considered, it would range between -0.80 and -0.85, which indicates a strong negative correlation. This is useful if a trader wants to trade on this range for the India VIX.
Suppose the VIX bottoms out near the 10-12 levels and is consistently near these levels for quite some time, the trader can assume that any factor, be it a geopolitical or economic occurrence could trigger an upward trend on the India VIX and take the Nifty down, where the Nifty can be traded on the short side.
Unless there are exceptional situations, the Volatility Index has peaked near 26-29 levels, which can be used as an indicator of the Nifty bottoming out. The trader can then initiate a long position.
Understanding the Volatility Index and its impact on the equity markets can be simple if you have been trading or investing in the equity markets for a while. As a newcomer, quite often, such terms, concepts and indexes may be complicated and to ensure that you grasp them better, some research can go a long way in helping you!
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Frequently Asked Questions
The Volatility Index is an indicator in the market that gauges the market risk levels. But studying these risk levels, the various market participants can make a move on their trades and investments to ensure their protection.
If you are new to the market and still getting to know the basics, understanding the VIX may be not be simple. After spending some time knowing the market movements and how different market indicators work, the VIX can be a useful tool.
It is possible that traders may undergo some losses if the market conditions are really volatile. However, the VIX readings are a reflection of the perceived fear in the market and so, based on the readings, traders should plan their investments and pick out the most suitable strategy possible.
No, the VIX and Nifty are different; the Nifty is a market index while the VIX is an indicator of the risk in the market. However, there is a negative correlation between the VIX and the Nifty.