In my previous article published a fortnight ago, I had highlighted a few drawbacks of how India volatility index (VIX) is not a very efficient tool for tracking sentiment. The same can be achieved with a greater degree of efficiency by tweaking VIX, something which was done and followed by a lot of people successfully?Smart Money Ratio (SMR)
SMR can be mathematical ratio of India VIX to the near month put-call ratio (PCR). The rationale behind this ? India VIX as can be recalled measures market?s expectation of volatility over the near term. In simple words higher the VIX, higher is the volatility. Unfortunately liquidity in index options beyond the current series is paltry ? to put it mildly. Hence the spread across bid and offers for such far month contracts tends to be huge. This then affects the calculation of VIX thus making it erratic at times. By dividing the VIX with the PCR of near month contracts the anomaly is cured to a great extend.
As seen in the graph, if we just rewind the clock back to Sep 08 and zoom in we can see that although the Nifty shut shop pretty close to 4,500 on September 8, the SMR was at a much higher level than where it was when the Nifty had its last close above 4,500 (September 2). That was also the SMR?s lowest close in many months.
In fact, though the Nifty closed higher on Sep 8 than on Sep 4, the SMR was higher on the 8th than it was on the 4th. All these were glaring examples of a negative divergence, which meant that 8th was just an aberration and the sell-off was about to begin.
This also brings to light the superiority of the SMR over the VIX. As is evident in the adjoining table, while the VIX has more or less stayed stable since the beginning of September?failing in the very purpose of its existence?the SMR has done its job almost perfectly. In fact, it?s ridiculous that the VIX actually fell over 7% after the dramatic meltdown on the 12th. So, if you go as per book, this means, at close on 12th Sep 08, the panic/fear in the market was the lowest since the middle of June which needless to say is far from the facts.
Similar trend reversals are pretty evident in Nov 08 and even for the recent rally that started in Mar 09. Critics may be right in pointing out flaws in the SMR, but then being dependant on VIX does come at a price. Else how does one explain VIX hitting 83.7 on 22nd May 09 and 62.05 on the 17th of June 09 even as market did not exhibit any serious directional movements. Given such anomalies in the VIX (officially launched index since Mar 08) a lot more thought process needs to be put in to differentiate method of calculation of India VIX vis-?-vis CBOE VIX. The success and the efficiency of SMR would greatly depend on that.
The writer is a derivative analyst