Thread by @vaibhavjain_vj

What is VIX?
Volatility Index.

What’s Volatility?
Expectation of the underlying’s deviation from what it is currently trading at. Assume underlying here as NIFTY Index.

If Nifty trades at 17,000, 1% volatility for 1 day means, expected to trade between +/- 1% 170 points.

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Coming back to VIX.
So, VIX is computed as an index which trades on the exchange. Just like we have other indices like Nifty, Sensex, Bank Nifty, etc and has a certain rule how they are computed, similarly, there are set of rules and formulae how VIX is computed.

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VIX is the original concept of US, to be precise, CBOE (Chicago Board Options Exchange). India got inspired and created its own VIX, largely based on similar set of rules of CBOE, but a slight tinge of local flavour – as of course US and India markets are different, right?

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How is it computed?
I really don’t want to go into how is VIX computed as that is largely beyond the scope of this article. For the simple reason is this starting formula:

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So, in easy terms:
VIX uses call and put options prices for different strike prices for current and next month expiry (so, today it will use Sep and Oct) with at least 3 days to expiry, which means, on Tuesday (28 Sep), it will switch to Oct and Nov.

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VIX value will tell you, how much movement in Nifty is expected over next 30 days.

Now, VIX is an annualised number. You need to calculate monthly number for that.

Yesterday close (16 Sep), India VIX was 14.41. This is annual.

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To get to monthly number, we divide this by square root of 12. Why? Because time is taken at 360 (proxy for 365) divided by the number of days for which we are computing. 30 here

Square root of 12 = 3.464
Hence, monthly volatility = 14.41 / 3.464 = 4.16
This is a %, so 4.16%
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Nifty closed at 17630 yesterday, so expectation of closing in 30 days is between 16897 and 18363.

Now we get to the real thing.
VIX is inversely proportion to NIFTY index. Not linearly, but sentimentally.

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This means, if there is a fear in market that it will go down, then VIX increases. This is hence also called Fear Index.

Why does this happen?

Call and put option premiums (or simply the prices which you trade) have 5 parameters theoretically on which it depends:

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– Strike Price
– Spot Price
– Time remaining to expiration
– Interest rates
– Volatility

Out of the above, the first four are known easily. For the volatility, if we use historical number, then we get theoretical value of call / put option.

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However, just like we can calculate intrinsic value of a stock using various valuation models like DCF, Multiples method, etc but stock trades somewhere else, because of course, supply-demand factors, same is for options.

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The trading price may be different from theoretical price and the reason is attributed to volatility. Because, in the equation, people fit in expected volatility, rather historical. And depending upon who is buying / selling, his expectations of volatility will be different.
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Now, we mostly have more people buying put options than call options. Why? Because many players use options to hedge their portfolios. For the uninitiated, value of put options increases when market goes down. So people hedge their portfolios by buying puts.
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The “fear” makes more people buying puts as the fear can only be from falling of the market.

When this fear is high (expectation of market falling is high), people rush to buy put options. This drives the prices of put options up.

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Not theoretically, but on exchange. In the above equation, this can only by explained by volatility. The “Implied” volatility becomes higher (think of the equation where you are solving for volatility with put option value taken from what it’s trading at).

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There’s also another concept called Put – Call parity. This means, option price of put and call are directly proportional (not linearly). So when put option price rises, call option prices also rise. Again, explained by the increase in Implied Volatility.

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This is the reason, VIX increases (which is calculated based on trading prices of call and put options) when the Nifty is likely to fall or is falling. More fear, you see.

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What happens when Nifty is going up? Things are calmer. Things are bullish. People are investing more in stocks. They are building up their portfolio. Speculators will buy call options but not likely as much as they buy put options in fear.

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#vix #indiavix