Brief about India VIX: India VIX is the volatility indicator formulated and computed by National Stock Exchange (NSE). It is dynamically updated in real time and measures the expected volatility in Nifty in the next 30 days. The calculation is complex and the main variable in this calculation is the option prices of OTM Calls and Puts. To read in detail about the history and methodology of calculation, click here.
The interpretation of India VIX is interesting (and confusing at the same time). In this article, I am making a sincere attempt to articulate my understanding of this volatility indicator. The straightforward interpretation of a rising VIX is that option writers are asking for more premium to take a position. In other words, the risk premium rises. VIX cannot be interpreted in isolation. It works best when clubbed with nature of upcoming event, technical analysis and fundamental phase of the market (PE expansion, PE contraction or consolidation).
Let us look at the different phases of VIX alongwith the different phases of Nifty and the broader market:
Rising VIX and market in technical uptrend/ downtrend: During this phase, generally the market is in a technical uptrend / downtrend and VIX rises gradually. My historical backtests prove that whenever VIX pauses or declines during such phases, the market resumes its trend. However, if VIX keeps rising without a respite, traders should become cautious and start cutting down positions gradually. Intraday trades should be avoided in this phase. It is best to trade with the trend in this phase.
Stable VIX in a consolidating market: Market consolidations are the most irritating phases that positional traders go through (Especially the ones who depend on trading for their primary income). It can be historically observed that when VIX starts moving in such cases, the market eventually takes a direction. It is important for traders to have an expectation regarding the direction of market movement (this may be fundamental or technical). Without having an expectation, there is little use of interpreting VIX.
VIX at relatively low levels and markets at near all time high: This is generally the beginning of a correction. How big the correction will be depends on the underlying fundamentals and prevailing state of the economy. For 2-way traders, this could be a good shorting signal (with defined stop-loss).
Declining VIX and market near critical supports: It happens many times that the market has significantly corrected and has come to a critical support mark. It so happened in Oct 2018 after the IL&FS default that Nifty reached the critical mark of 10000. The correction started from its all time high of 11760 in late August. Such entry points are extremely lucrative and tempting. However, after having witnessed a great fall like this, it is difficult to dare and put your hand under a falling knife. VIX comes handy in such cases as a supporting indicator. In the week ending 22nd October and 29th October 2018, the market reached its bottom at 10005. The week ending 5th November witnessed a declining VIX. This was a great entry point for a long trade. As usual, stoploss needs to be defined in all such tactical trades, where one is opposing massive momentum in uncertain times.
I have posted below charts of nifty and India VIX for the readers to easily refer while reading. You may use your charting softwares for analysing the correlation in detail.
The VIX puzzle: When I started studying this indicator in depth, I wanted to know 'VIX moves the market or market moves the VIX'? This puzzle is very similar to the classic 'Chicken and Egg puzzle'. Let us look at both aspects of the argument:
The fact that option writers are market makers in most phases of the derivatives market, implies that they have higher control over the cash market as well. In such a scenario, it is likely that the risk premium rises before the market movement starts.
The other end of the argument is 'How can the option writers know exactly when to ask for higher premiums (in the short term). There has to be some trigger for the option sellers to ask for a higher premium and the option buyers to agree to that premium. From this aspect it is apparent that the market moves the VIX.
My interpretation of this puzzle: VIX is the expectation of volatility in future that traders have. This expectation is mostly in anticipation of the outcome of a major event (mostly geo-political). This subjective and qualitative 'expectation' leads to a general 'opinion' amongst market participants and hence risk premiums increase gradually over a period of 3-4 weeks. This is a systematic and planned rise in VIX over the medium term. Consequently, it is safe to assume that on longer time frames, the VIX moves first and then the market. On shorter time frames, when there is no 'expectation' or 'opinion' amongst the market participants, it is very likely that the market moves first and as a reaction to that the risk premiums rise.
Conclusions: a. VIX should not be interpreted in isolation. It works well with supporting technical indicators, fundamental phase of the market and most importantly the nature of upcoming event. VIX works better on longer term charts(weekly or monthly).
VIX should not be interpreted in isolation. It works well with supporting technical indicators, fundamental phase of the market and most importantly the nature of upcoming event. VIX works better on longer term charts(weekly or monthly).
It is important to understand the difference between gradual rise in VIX and abrupt rise. The gradual rise brings in volatility in short term charts, but longer term charts tend to follow the ongoing trend.
Like any other indicator, decisions based on VIX have a probability of failure. Trading decision should never be based on any single indicator. VIX is just for confirmation. The experienced traders would agree: Trading is all about probabilities and taking calculated chances.
The most common mis-conception about VIX is that when VIX moves up, the market goes down (even I had this mis-conception before I studied VIX in detail).