11 - Understanding VIX and Its Role in Trading

 

Understanding VIX and Its Role in Trading

Introduction Welcome, everyone! Today, we are diving into an important topic that not many traders understand fully, yet it plays a crucial role in both mitigating big losses and helping you make profitable trades. This lesson will cover the concept of the VIX (Volatility Index), its significance, and how you can use it effectively in your trading strategy.

What is VIX? VIX stands for Volatility Index, and as the name suggests, it is a measure of the volatility or price fluctuations in the market. Essentially, it tells us how much the market is expected to move (up or down) in a given period.

When we talk about VIX, in the Indian context, we refer to India VIX, which measures the expected volatility in the Indian market, specifically Nifty. Currently, for example, if the India VIX is around 23, it means the market can potentially move up or down by 23% within the next year.

Official Definition from the NSE According to the NSE website, the VIX is a measure of the market's expectations of volatility over the next term (typically one year). The higher the VIX, the higher the expected volatility, and vice versa. In simple terms, a high VIX means that there’s more uncertainty in the market.

VIX is often called the "Fear Index" or the "Risk Index" because it tends to increase during times of uncertainty—when there’s news, announcements, or events that could affect the market. This increase in the VIX indicates that there is more fear or anxiety among traders.

How is India VIX Calculated? India VIX is based on the prices of Nifty options, particularly the out-of-the-money options. This gives us a sense of the volatility expected in the market. The VIX range can be anywhere from 0 to 100. However, it usually stays within a specific range. For example, typically, VIX hovers between 10 to 20, but during periods of extreme uncertainty, like during the COVID-19 pandemic, it spiked to higher levels (even as high as 86) due to the increased market volatility.

Market Behavior and VIX During times of high uncertainty, such as upcoming major events like the budget announcement or an RBI policy meeting, the VIX tends to rise. This is because traders are unsure about the market’s direction, and therefore, fear increases. This is where VIX serves as a helpful tool—it shows you when market conditions are becoming risky.

On the other hand, when the market is moving smoothly and the fear level is low, the VIX usually stays at lower levels.

How to Use VIX in Trading Now that we understand what VIX is and how it behaves, the next question is: How can we use VIX in our trading strategies?

1. Calculating Monthly Volatility

If the current VIX is 23, we can calculate the monthly volatility by dividing the VIX value by the square root of 12 (since there are 12 months in a year). Let’s break it down:

• The VIX value = 23
• The square root of 12 is approximately 3.464.

Monthly volatility = 23 ÷ 3.464 = 6.64%

This means that, based on current data, Nifty could move up or down by 6.64% within the next month.

2. Calculating Weekly Volatility

If you want to know the expected volatility for a week, you can divide the VIX by the square root of 52 (because there are 52 weeks in a year). The square root of 52 is approximately 7.2.

Weekly volatility = 23 ÷ 7.2 = 3.19%

This means that the Nifty could move by around 3.19% either up or down within a week.

3. Daily Volatility

If you’re interested in understanding the daily volatility, the calculation is simple. Divide the VIX by the square root of 365 (since there are 365 days in a year).

Daily volatility = 23 ÷ √365 = 1.2%

This tells us that, on a typical day, the market could move by about 1.2% in either direction.

What Does This Mean for You? Using VIX, you can understand the potential market movements on a monthly, weekly, and daily basis. By knowing how much the market is likely to move, you can set your trades accordingly, whether you’re trading options, futures, or spot markets.

For instance, if the VIX is high, indicating high volatility, you may want to avoid high-risk trades or take steps to hedge your positions. Conversely, if VIX is low, you may feel more confident entering trades, as the market is likely to remain stable.

VIX and Market Sentiment

The VIX not only tells you about the market’s volatility but also about its sentiment. A rising VIX often corresponds with market fear and uncertainty, while a falling VIX suggests calm and stable market conditions.

Example of VIX During Major Events: Let’s take the budget announcement as an example. Before the announcement, the market will likely be uncertain about the outcomes, so the VIX will rise. After the announcement, whether the news is positive or negative, the VIX might either drop back down (if the news is clear) or continue to rise (if there’s confusion or further fear).

VIX Slabs and Risk Levels

To make it easier to interpret VIX readings, we can divide them into specific ranges:

• 9 to 14: Low Volatility (Market behaving normally)
• 15 to 18: Moderate Volatility (Minor uncertainty in the market)
• 19 to 24: High Volatility (Market showing significant fear or uncertainty)
• Above 24: Very High Volatility (Extreme market conditions)

When VIX crosses 19, you should become more cautious because it indicates that the market may experience larger-than-usual movements.

Conclusion

Understanding and utilizing the VIX can significantly enhance your ability to predict market movements and manage risk effectively. Whether you're an options trader, a swing trader, or even an investor, knowing how to read and apply VIX data can help you make better-informed decisions. Keep an eye on the VIX, especially before major market events, and adjust your trades accordingly to protect your capital and potentially maximize your profits.

That’s all for today’s lesson. We hope you now have a clear understanding of what VIX is, how to calculate market volatility, and how to use this valuable tool to improve your trading strategies. Keep practicing, and happy trading!