Given the BSE Sensex?s latest round of gyrations, this is just the appropriate juncture for traders to start watching a volatility index of the market?s own. That the regulator Sebi has given the go-ahead for such an index, therefore, is a good cause for cheer, even if the share price indices suggest otherwise. A volatility index, as the name suggests, tracks the amplitude of the up and down swings. But not as a simple standard deviation measure of the price index, which is easy to calculate but is of little use in looking at the future. It does the job instead by measuring the active calls being taken on future price swings by investors. By the Vix model in common use overseas, this is done on the basis of ?implied volatility? in the prices that derivative investors pay for options (they pay more for yo-yoing assets since the likelihood of these exercised is higher). This way, it reflects the market?s mind on future prices. That Sebi has allowed such a volatility index is a sign that it thinks that the market for futures and options in India has gained sufficient depth for it to be of operative value. Its very existence is likely to increase this market?s depth as well, which will make the index better. Mature trading platforms across the world have well-watched volatility indices, and these serve as a valuable tool?even for retail investors?to gauge the turbulence of markets.
A volatility index does not make market risk disappear, or even contain the phenomenon. That is not the purpose. Rather, it helps investors surf the waves better, and it is well known that in a market with fully functional derivatives, there is also money to be made under circumstances of rapidly changing prices. The big broad gain from such an index is the clear information advantage that will come from knowing what is going on in clear numerical terms. Implied volatility in itself is useful information, and the prices at which options sell has much to say about market expectations. This, in itself, will act as a draw. So expect the index to lure more investors towards options trading. At higher levels of analytical sophistication, a volatility index will help traders project future price movements on the basis of advanced computer-based simulations that try and predict price instability. This is good. A better informed market is always a more efficient one.
