India VIX explained: What is India VIX and how does it work?

[ecis2016.org] Here’s all you need to know about India VIX or India Volatility Index that helps investors and traders gauge the market volatility and make suitable investment decisions.

The stock market is known to be volatile, with a high level of volatility implying that there may be drastic upward and downward movement in the prices of stocks over a short period. Market investors may have come across terms such as the fear index or the Volatility Index. It is important to know about the India VIX or India Volatility Index, which helps investors and traders in India understand the volatility-induced fluctuations. In this article, we will discuss all about VIX India and its significance which can help you make informed investment decisions.

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What is India VIX?

India VIX or India Volatility Index, a real-time index calculated by the NSE (National Stock Exchange), is a measure of the expected market volatility over the next 30 days in the Nifty50 Index. Volatility figure is expressed as a percentage. India VIX is the first volatility index introduced in India in 2008 by the NSE and is based on the original concept introduced by the Chicago Board Options Exchange (CBOE). In 1993, the CBOE first introduced the volatility index for the US market, based on S&P 100 Index option prices. In 2003, the methodology was modified and the new volatility index was based on S&P 500 Index options. 

Normally, the volatility index tends to rise when the market witnesses continuous fluctuations, that is, when there is an increase in volatility. Usually, volatility is described as the rate and magnitude of the price changes and is also referred to as risk. When the volatility subsides and the market witnesses lesser fluctuations, the volatility index drops.

For stock market investors and traders looking to gain from a trading environment that is changing rapidly, it is essential to be aware of the changes in the Indian VIX levels, which indicates the volatility of the market. This helps in getting the right perception of the market conditions when monitoring one’s investments or before going for new investment. One should expect higher volatility in the case of higher India VIX values. Similarly, a lower India VIX will mean lower volatility in the market.

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India VIX vs Nifty

The Volatility Index or VIX differs from a price index such as Nifty. The price index is calculated by considering the price changes of the underlying equities. On the other hand, India VIX, which is represented in the form of a percentage, is calculated based on the order book of the underlying index options. Typically, India VIX and Nifty have demonstrated a negative correlation. That is, the Nifty falls when the volatility index rises and vice versa. India VIX is a value used by many market investors and traders. If India VIX rises and fear in the market increases, Nifty falls. This India VIX level may indicate a favourable time to invest in the share market.

India VIX: Significance and application in the Indian market

India VIX helps investors and traders gauge the market volatility and assess the market risks for equities. If the market volatility increases, the intraday traders see the risk of frequent stop losses getting triggered. So, they may look to either choose to lower their leverage or expand their stop losses. Understanding the market situation, which is indicated by the India VIX, helps them make better decisions.

VIX is a good indicator for long term investors who are not much impacted by short term volatility. If the market continues to move up over a period, the investments are likely to appreciate. However, institutional investors have restrictions in terms of risk and MTM losses. The India VIX helps get an indication of the rising market volatility. Those involved in options trading can also use the India VIX indicator for deciding on buying or selling an option. If the market volatility is expected to increase, options tend to be more valuable for buyers who can expect gains.

Let us take an example.

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Suppose the India VIX level today is 10. It implies that traders, given the bid and ask prices of options, can expect the market volatility to be 10% in the near term over the next 30 days. The percentage of 10 represents an annualised volatility figure. Thus, over a period of one year, the 10% movement indicates low volatility. One may expect the Nifty to be in a range of +10% and -10% from the current Nifty value for the next year over the next 30 calendar days. Considering earlier trends, India VIX and Nifty have an inverse correlation. Ideally, the VIX value ranges between 15 and 35. A value below 15 indicates low volatility and above 35 can be considered high volatility.

How is India VIX calculated?

India VIX is based on the computation methodology of the CBOE with appropriate modifications to adapt to the Nifty options order book.

The value is derived using the Black and Scholes model, known as the B&S model. The index applies five variables namely the strike price, the market price of the stock, time to expiry, risk free rate and volatility. The VIX India value is established by the bid-ask quotes of near and next month Nifty options contracts traded on the NSE’s F&O segment.

The India VIX calculation is based on a complex mathematical formula. We discuss below the different factors based on which the index is calculated: 

• Time to expiry: It is calculated in minutes and not days, for attaining a level of precision expected by professional traders.
• Interest rate: The relevant tenure rate, which is for 30 days or 90 days, is considered as risk-free interest rate for the corresponding expiry months of Nifty option contracts.
• The forward index level: The calculation of India VIX is done using out-of-the-money option contracts that are identified using the forward index level. The forward index level enables in establishing the at-the-money (ATM) strike that helps in selecting the option contracts considered for calculating the India VIX. The forward index level is considered as the latest available price of the Nifty future contract for the relevant expiry month.
• Bid-ask quotes: The strike price of the Nifty option contract is the ATM strike which is available at a level below the forward index level. The bid and ask quotes of the options contracts are considered when computing the India volatility index. After the quotes are identified, the variance (volatility squared) is calculated separately for near and mid-month expiry. The variance is calculated by providing weightage to each Nifty option contract identified for the calculation, based on the CBOE method. The weightage of a single option contract is inversely proportional to the option contract’s strike price and directly proportional to the average of best bid-ask quotes of the option contract.

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