India VIX is the volatility index designed by the National Stock Exchange (NSE) in the year 2008 . It gives an estimate of the market participants' expectation of volatility in the near term. The important point to note here is that this expectation is only for Nifty index. India VIX does not include the expectations for non-Nifty shares. Nifty spot price is the weighted average of the constituent share prices. The value for VIX is derived using the order book of underlying Out of money (OTM) options (We will see the computation methodology in greater detail later in this article).
The VIX values are updated dynamically in real time basis by NSE. Participants can see the index values just by adding them in their trading account watchlist. VIX is computed using the bid-ask quotes of near and next-month Nifty options contracts. The exchange makes sure that exorbitantly high or low values for bid-ask quotes are not entered by market participants. There are circuit limits applicable in options too(only at the time of order placement). There is no circuit limit on option prices when the underlying share/index moves.
Computation methodology The calculation for India VIX is complex and involves heavy mathematics. I would not discuss the exact formula for calculation (I do not want to scare the non-math savvy readers of this blog). Honestly, more than the calculation formula, the conceptual understanding and its application in trade is important.
VIX is a function of the following variables:
Time to expiration: This is the most important variable in calculation of VIX. The value of VIX is directly proportional to the Time to Expiration (TTE as is commonly called in options terminology).
Weightage given to deep OTM options: As mentioned above, VIX uses the bid-ask quotes of out-of the money (OTM) options. More weightage is given to options that are further away from the spot price. For example: With Nifty spot price 11650, weightage will be given as below: For calls: weight(11700) < weight(11750) < ...< weight(11900) For puts: weight(11600) < weight(11550) < ...< weight(11400).
Risk free rate: The NSE MIBOR rate is used as the risk-free rate for calculation of VIX.
Nifty futures level: For deciding the OTM strike prices, futures price of Nifty is used instead of the spot price. For example if Nifty spot price is 11580 and futures price is 11640, then the strike prices to be considered for calls are 11700 and onwards; the strike prices for puts are 11550 and below.
How VIX started? VIX or volatility index is a trademark of the Chicago Board of Options Exchange (CBOE). CBOE started the concept of volatility index in the year 1993 based on S&P 100 index options. In 2003, the underlying index was changed to S&P 500. During periods of high volatility like geo political events, market generally moves upward or downward sharply. The CBOE probably realised the importance of having a standardised index for tracking volatility. Imagine how much this index would have helped the experienced traders during the 2008 crash ( If your curiosity levels are generally high, just check the VIX chart for S&P 500 during the 2008 crash). This movement leads to movement in the volatility index. Investors and traders use this index to gauge the future volatility.
Conclusion: VIX is a concept introduced in the USA by CBOE and replicated in India by the NSE under the name India VIX. The computation methodology is same as the original VIX. The calculation of VIX is complex and involves a complex formula. This article is an attempt to explain the complex formula in simple terms. Application of the index is more important than the calculation.
Watch this space for more about the application of VIX in trading.
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