Understanding the Calculation and Applications of VIX and India VIX
The VIX or Volatility Index measures the market's expectations of future volatility based on options prices for the SP 500 index. Similarly, the India VIX measures the anticipated market volatility in the near term based on NIFTY options. Both indices are widely used by traders and investors to make informed decisions. This article will provide a detailed breakdown of how these indices are calculated and their applications in the financial markets.
How is VIX Calculated?
The VIX uses prices of SP 500 index options, both call and put options, with near-term expiration dates. Specifically, it focuses on options with at least 23 days and no more than 37 days to expiration. The calculation considers a range of strike prices to capture the market's expectations of volatility, including out-of-the-money, at-the-money, and in-the-money options.
The VIX calculation employs a weighted average of the option prices. The weights are derived from the strike prices and the time to expiration. The formula for the VIX is given by:
VIX 100 times sqrt{frac{T}{365} sum frac{CK - PK}{K^2}}
T is the time to expiration in days. CK is the price of call options. PK is the price of put options. K is the strike price.The result is annualized to express the expected volatility as a percentage. The VIX is continuously updated throughout the trading day based on changes in options prices.
What is India VIX?
The India VIX is a volatility index calculated by the National Stock Exchange (NSE) from the order book of NIFTY options. It measures the market's anticipation of volatility in the near term, specifically over the next 30 calendar days. When the market is highly volatile, the India VIX tends to climb, and vice versa.
The India VIX is calculated using the best bid-ask quotes of near and next-month NIFTY options contracts traded on the NSE's financial options (FO) segment. The forward index level is identified using the most recent available price of the NIFTY future contract, and the relevant tenure rate is used as the risk-free interest rate.
India VIX: Computation Methodology
The computation of the India VIX involves several key components:
The forward index level is used to determine the at-the-money strike. The relevant tenure rate is considered the risk-free interest rate for the respective expiry months. The time to expiry is calculated in minutes, not days, for greater precision. The CBOE's computing technique is adapted to the NIFTY options order book.Applications of VIX and India VIX
The VIX and India VIX serve as excellent indicators of market risk for various types of traders and investors. Here are some key applications:
Intraday Traders and Short-Term Investors
Intraday traders and short-term investors use the VIX to monitor market volatility. When volatility is expected to spike rapidly, they may need to adjust their stop-loss levels or leverage. An increasing VIX can indicate rising market uncertainty, prompting traders to manage their risk more closely.
Long-Term Investors
Long-term investors generally do not worry about short-term volatility. The VIX can inform them about potential shifts in market dynamics. However, institutional investors and proprietary desks may have risk and mark-to-market (MTM) loss restrictions. A rising VIX might prompt them to increase their hedges, such as purchasing puts, to manage potential risks.
Options Traders
Options traders rely heavily on the VIX and India VIX to assess implied volatility. By understanding the expected movement in volatility, options traders can make more informed decisions about buying, selling, or hedging strategies. The VIX and India VIX play a crucial role in options pricing models and risk management.
By understanding how the VIX and India VIX are calculated and their applications, investors and traders can better navigate the complexities of the financial markets. These indices provide valuable insights into market expectations, helping participants make more informed decisions.