Reading the markets through volatility index
Volatility index or India VIX last week captured traders’ attention when it plunged nearly 20 per cent during intra-day on April 23, to 9.8, even as the process of General Elections to the Lok Sabha just began. However, the index bounced back a little and is currently ruling around 11. The sudden fall caught a lot of traders, who indulge in strategic option strategies such as strangle and straddle, off-guard as the premium dipped sharply. This also signalled that traders are more complacent.
Volatility index, known as fear gauge, captures the expected near-term movement — upside or downside — of the underlying index (Nifty50).
According to the National Stock Exchange (NSE), India VIX is a volatility index based on the Nifty 50 Index option prices. From the best bid-ask prices of Nifty 50 options, a volatility figure (per cent) is calculated, which indicates the expected market volatility over the next 30 calendar days.
CBOE index
India VIX was introduced in 2008 by Nifty on the lines of CBOE Volatility index.
According to Investopedia.com, the CBOE Volatility Index is a real-time index that represents the market’s expectations for the relative strength of near-term price changes of the S&P 500 Index (SPX).
Similarly, India VIX is computed by the NSE based on the order book of Nifty options. For this, the best bid-ask quotes of near- and next-month Nifty options contracts, which are traded on the F&O segment of the NSE, are used. India VIX uses put and call options in the near- and next-month expiration, in order to bracket a 30-day calendar period.
The India VIX hit an all-time low of 8.7 in May 2008 during intra-day trading. The fear gauge touched a high of 92.53 on November 14, 2008, when the bear market was at its peak.
Volatility index zoomed to a high of 83.61 in March 2020 on the back of the Coronavirus-led pain. Since then, it was in the broad range of 35-15. The fear gauge has been hovering around the 11-14 range since December 2022.
However, CBOE volatility has been relatively volatile as it swung between 36 and 12 in the last four years. It has been on a secular uptrend since December 2023 from around 12 level and currently hovering around 15.65. During the period, the three major US indices — Dow, Nasdaq and S&P 500 — saw huge volatility.
Comfort zone
The comfort zone for the volatility index is between 11 and 15. Past trends suggest that whenever the index hovered around these levels, market hit the peak and the bull rally is prolonged quite comfortably. However, if it slips below 11, one has to be very careful, as the market may turn volatile again. This signals the index is in overbought condition and reversal in trend is highly likely.
On the other hand, a prolonged movement between 25 and 35 indicates a bearish sentiment. During this period, market tends to witness multiple correction, and investors, especially traders, need to be careful
However, a rise of above 60 indicates an oversold zone, which is a good time to accumulate quality stocks. But whenever the volatility index breached 60-level, it cooled off within a few days.
Currently, Nifty has only volatility VIX based on Nifty50. However, with traders’ interest high on banking and financial services stocks, the time has come to consider introducing a similar gauge based on Bank Nifty as well. This lead indicator will definitely help traders of Bank Nifty to assess their risk and take informed decisions.