Volatility is known as a measure of change. A higher value of volatility indicates that prices can change at a faster pace (either going up or down) as compared to the immediate past.
Traders are often looking for new strategies to trade a major event, say a Election Results or Union budget or credit policy or even important results like Infosys. Normally a trader would have bought, what an option trader calls a Long Straddle strategy. In entering this strategy, he would buy a long call and a long put option of the same strike price and same expiry.
In order to earn profits from such a strategy, markets need to move sharply in either direction such that profit from one direction would be more than the loss from the other one. However, the strong following of such a strategy leaves very little on the table (if at all) as prices of both the call and put option rise before the event as they all fear the extreme.
Traders will now have an instrument to earn from such an eventuality. NSE recently launched India Vix Futures for traders who are willing to bet on volatility. India VIXis a volatility index based on prices of Nifty options.
Before you start trading the India VIX futures contract, here are few points to consider
- Globally known as a ‘fear index’, VIX is actually one of the best contrarian indicators in the world. Chicago Board Options Exchange (CBOE) which owns the Vix trademark say that since volatility (high) often signifies financial turmoil, VIXis often referred to as the investor fear gauge. The index is colloquially referred to as the fear index.
- In India, value of VIX has been computed by the NSE since November 2007 based on the out-of-the-money (OTM) option prices of the Nifty. It has touched a high of 85.13 and a low of 13.04. As it is mentioned in percentages, value of VIX can never be below zero or more than 100.
- Historical data indicates that India VIX has a strong negative correlation of negative 0.8 to the Nifty. This means that every time VIX falls, Nifty rises and every time it rises, it means that a fall is imminent. India VIX touched a value of 85 percent, a few days before Nifty touched a bottom post the Lehman Crisis.
- India VIX has a mean of 26.65 and a median of 23.83, these figures are important for option writers and traders since VIX has a tendency to revert to the mean.
- The India VIX futures contract will have a weekly settlement and have three running contracts along with three spreads between the contracts (spreads are the difference in prices between two contracts). One need not have the vision of a planning commission or a economist to trade the contracts. A smaller vision of one week or a maximum of one month is good enough to determine the volatility. Shorter term VIX indices are more responsive to short term volatility which will be induced due to corporate earnings, government policy announcements or RBI’s policy changes.
- Volatility is easier to predict than price. One will not know the price of Infosys after it announces its results, but it is easier to know that volatility will increase immediately after profit and guidance numbers are announced by the company’s management.
- VIX futures are also considered to be a better hedge than a index future.This is because VIX indices are more volatile and offered three to four times more returns than an asset based index. The recent 5.4 per cent drop in the Nifty between January 23rd 2014 and February 13, 2014 resulted in a 14.8 per cent change in the volatility index.
- The high gains are precisely the reason why speculators are attracted towards it. NSE however, has kept the lot size for each contract at around Rs 10 lakh which will attract a margin of Rs 2 lakh, thus making the product more expensive for the retail investor.