After a meteoric rise in the stock markets that have delivered over 40% returns in just over a couple of months, the first sign of fatigue was seen in the week gone by. Starting out on a pretty flat note, selling pressure intensified into the week with no sectors beings spared the blushes.
As this offloading was happening, it was very interesting to note that traders abstained from creating sizeable short positions even though the bulls were running out of steam. One could attribute this to resilience shown by the markets in clawing back from the intraday lows. These swings of over 70-80 points, or even 150 points at times, gave rise to volatility thereby getting a lot of trades on either ends stopped out.
Speaking of volatility, NSE launched India VIX – (volatility index) in March 2008. Volatility Index measures market?s expectation of volatility over the near term. Volatility here refers to rate of changes in prices or risk. Denoted in percentage, higher the VIX higher is the volatility.
The index does not tell about the price movement but the risk associated with the stocks (in the Nifty 50). Normally in a range bound or mild upside market, VIX is low while in case of selling pressure, value of VIX rises. If value of India VIX is above 30, then market is perceived fragile, if above 40 it is uncertain while above 50 market is dangerous.
The behaviour of VIX and subsequent Nifty levels is depicted in the chart (above).
Going by the text book definition of VIX, every rise or fall in the market can be preempted based on the value of VIX. Hence it serves as an early warning signal. However, a little peek into how values of VIX are calculated throws up an interesting fact. Volatility index calculation requires two pairs of options that are used from each series. Each pair consists of one call and one put with the same strike. In total, eight options must be used. The implementation of the method assumes a very liquid market.
A detailed computation methodology is available on the NSE website.
But this value does not always present a true sentiment of the market as it is dependent on the liquidity of the index option contracts in the mid month contracts. Sample this – Nifty Aug 4,400 strike calls has a bid at 51.30 while offer is at 869.50, Nifty Aug 4,600 strike calls has bid at 51.2 while offer stands at 332.9. No contracts were traded in these strikes. In fact Nifty Aug puts portrays an even dismal picture. (All bid/offer quotes are as on 17th June 09)
Hence by virtue of these impractical pricing, the VIX tends to be erratic at times, as seen in the last spike in May 09 on the chart, which did not change the trend as it had done in the past. Although VIX was launched a little more than a year ago, its values have been derived dating back to 2007.
The same, when plotted against Nifty too yields erratic spikes. Thus VIX standalone cannot be used as an effective indicator to gauge market volatility. An improvised version of VIX coupled with put call ratio (volumes) is a much more formidable tool to judge volatility in the market.
The writer is a derivatives analyst