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What is Volatility Index how it impacts Options pricing

25 Jul 2022 0 COMMENT

India VIX, which is the acronym for the India Volatility Index, is an implied volatility index representing the expectations of the market for the relative strength of any near-term price changes of the NIFTY Index options. It means that this real-time index is derived from the prices of the NIFTY index options having near-term expiration dates and it generates a forward projection of the volatility in these prices for the next 30-days.

The India Volatility Index was first introduced in the year 2008 by the National Stock Exchange (NSE). The origination of the concept of a volatility index can be traced back to the year 1993, when the first volatility index was introduced by the Chicago Board Options Exchange.

One should keep in mind the difference between a price index like NIFTY and a volatility index like the India VIX. A price index, for example NIFTY, is calculated by taking into account the price movement of the stocks which are included in the NIFTY index. Whereas the volatility index, which is India VIX in this case, is computed by making use of the underlying index options and is represented in the form of an annualized percentage.

Since its inception, India VIX has been used as a measure of gauging the volatility in the markets and also used by a number of market participants in framing their investment decisions.

It is important to understand the concept of volatility before getting to know how the value of India VIX is determined. Volatility is essentially a measure of how quickly the prices change, or in other words, it represents the amount of fluctuations in a security’s price over a given time period. Volatility can be calculated by computing the variance between the price of an asset and a market index, which is the NIFTY index in the case of India VIX. Generally speaking, higher the volatility, greater is the risk associated with the security.

VIX measures the Implied volatility, which is a likely movement in the price of a security as forecasted by the market. It is a measure of estimating any fluctuations (volatility) in the price of the security in the future, on the basis of some predictive factors. Typically, implied volatility tends to increase in bearish markets and decrease in bullish markets. Time periods associated with greater market uncertainty which are characterised by higher expected future volatility give rise to higher VIX values and relatively stable times correspond to lower VIX values.

As an example, if the value of India VIX is 13.8495, it is representative of an expected annualized change of 13.8495% over the next 30 days.

Computing the value of India VIX

In order to obtain a value for the India VIX, the NSE employs a computation methodology similar to that used by the CBOE along with some suitable changes which adapt the process to the NIFTY options order book. This computation of India VIX is carried out using the best bid-ask prices of NIFTY options contracts and the prices of these calls and puts are used to calculate the volatility. The below listed factors are instrumental in obtaining the final computed value of the volatility index:

1. Time to expiry

The computation of the time to expiry is done in the magnitude of minutes rather than days in order to arrive at precision levels which are deemed as acceptable by professional market participants.

2. Interest rate

The interest rate, also known as the risk-free interest rate, is the relevant tenure (30 days or 90 days) Mumbai Interbank Offer Rate, or MIBOR rate, which is the rate at which banks can borrow funds from other banks in the Indian interbank market. In the subsequent computation, this is the interest rate for the respective expiry months of the NIFTY options contracts.

3. Forward index level

The computation of the value of India VIX is carried out using Out-of-The-Money (OTM) option contracts, and these option contracts are identified using the forward index level. This forward index level is helpful in computing the At-The-Money (ATM) strike which assists in selecting those options which will be used for the computation of the value of the India VIX. The forward index level which is used is the latest available price of NIFTY futures contract for the respective expiry month.

4. Bid-Ask quotes

The At-The-Money (ATM) strike described above is the strike price of the NIFTY option contract available which is just below the forward index level. Out-of-the-money options are identified as NIFTY calls with their strike price just above the ATM strike and NIFTY puts with strike price below the ATM strike. The computation of the value of the India VIX is carried out using the best bid and ask quotes of these options contracts.

Once these quotes are identified, the variance, which is obtained after squaring the volatility is calculated separately for both, the near and mid-month.

Finally, the variance which was computed for both the near and mid-month expiry are interpolated to obtain a single value of variance having a constant maturity of 30 days to expiration. After this, the square root of the above obtained variance is calculated and multiplied by 100 to get to the value of India VIX.

VIX does the job of consolidating all the associated implied volatility values on various options on the NIFTY Index and gives a single number which represents the volatility of the overall market.

This is where a salient feature of the volatility index is highlighted. India VIX has a strongly negative correlation with the NIFTY index. Generally, India VIX ranges between the values of 15-35. During the initial phases of the COVID-19 pandemic, there was widespread turmoil and volatility in the stock markets all throughout the world, and as a result, India VIX had climbed up to its highest levels of 83 for that period of time. Once the markets corrected, the value of India VIX also stabilized.

India VIX is also colloquially known as the ‘fear-index’, the reason for which can be attributed to the expectations of volatility to rise and fall. But it should be noted that higher levels of India VIX is not necessarily associated with a bearish outlook, it is instead a metric which is used to perceive volatility levels in either directions, including both the upside and downside movements.

Volatility is one of the key components of option pricing, and is incorporated within the premium, which is the price one needs to pay to buy an option. If one were to expect the volatility of an index, which is the NIFTY index to increase or decrease, the option premium is also bound to increase or decrease. This is why option premiums can possibly be informative in understanding any expectations of any price action and future volatility.

Since VIX is a representation of the expectation whether the volatility will rise or fall, it means that if there is an underlying expectation of quite a bit of volatility in the market due to events like an economic recession for example, then the value of VIX will increase to higher levels. Conversely, if the market expects a relatively non-volatile atmosphere, then the values of VIX will potentially decrease. 

VIX and options pricing

VIX is one of the most popular metrics for assessing the volatility of the markets, and volatility is also instrumental in determining the premiums of stock and index options. Therefore, VIX does have a considerable impact on options pricing. Typically, higher values of VIX translate to more expensive option premiums and comparatively lower values of VIX correspond to relatively cheaper option premiums.

The reason behind higher levels of volatility and consequently higher levels of VIX leading to higher option premiums is because the option writers are exposed to theoretically unlimited risk with a limited reward, which is the premium. This is why option writers charge a high premium during times of high volatility so as to minimize the associated risk.

VIX as a contrarian indicator

Since India VIX and the NIFTY index are inversely correlated with each other (fear-index), higher values of India VIX reflect increased levels of investor fear and uncertainty and lower values of India VIX suggest relative stability.

According to the contrarian methodology of investing, which is essentially the practice of investing against popular market sentiment, higher levels of India VIX potentially correspond to a suitable time to buy while lower levels of India VIX indicate that one should liquidate.

Higher levels of India VIX usually signal that the market sentiment is excessively bearish, and the implied volatility associated with the underlying has reached its maximum capacity. This is usually indicative of the fact that the market is likely to turn bullish.

Conversely, lower levels of India VIX signal that the market sentiment happens to be too bullish, and its likely that the implied volatility is bound to rise, thereby indicating that the market is possibly bound for a downturn.

Conclusion

India VIX, or the volatility index in general, is a useful tool for market participants to analyse the market movements and gauge the underlying sentiment around volatility and also act as a factor in making investment decisions.

Disclaimer: ICICI Securities Ltd. ( I-Sec). Registered office of I-Sec is at ICICI Securities Ltd. - ICICI Venture House, Appasaheb Marathe Marg, Prabhadevi, Mumbai - 400 025, India, Tel No : 022 - 6807 7100. The contents herein above shall not be considered as an invitation or persuasion to trade or invest.  I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon. The contents herein above are solely for informational purpose and may not be used or considered as an offer document or solicitation of offer to buy or sell or subscribe for securities or other financial instruments or any other product. Investments in securities market are subject to market risks, read all the related documents carefully before investing. The contents herein mentioned are solely for informational and educational purpose.