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The India VIX is a metric that is calculated using the Black Scholes Options pricing model (Photo: Mint)
The India VIX is a metric that is calculated using the Black Scholes Options pricing model (Photo: Mint)


Long-term investors are better off investing their money in the stock market through SIPs

Volatility, as defined by the Oxford English dictionary, is the quality in a situation of being likely to change suddenly. That is a phenomenon most commonly seen in the stock markets and is considered to be a perennial source of misery for most market participants since the extent of the swings determines the fortunes that can either be made or lost in the stock market.

To be sure, not all investors consider it a negative influence. Some investment gurus have even labelled it as an opportunity to buy undervalued companies. That is perhaps why Warren Buffett said “the true investor welcomes volatility".

For the benefit of investors, stock markets have a dedicated index to measure volatility. The VIX, or volatility index, is used by investors to measure market risk, fear and stress, before they make investment decisions. For instance, the India VIX is a measure of how much the Nifty 50 index is expected to change in the next 30 days. It tells us how unpredictable the market is likely to be. If the India VIX is high, it means there is a lot of uncertainty and fear in the market. If it is low, it means the market is more stable and predictable. However, the VIX also tends to mean revert and its current level is unusually low.

Graphic: Mint
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Graphic: Mint

VIX and options

The VIX is related to options pricing, and so here’s a quick guide to what options mean. Options are financial contracts that give the holder the right to buy or sell an underlying asset at a predetermined price within a specified time frame.

There are two types of options: Call options give the holder the right to buy the asset at a certain price, while put options give the holder the right to sell the asset at a certain price. Call option buyers take the view that the market will rise while put option buyers take the opposite view. A third view is that volatility will happen, without specifying the direction of the swing. This means investors take a considered view on the VIX rather than the stock market movement.

The India VIX is a metric that is calculated using the Black Scholes Options pricing model. It takes into account five variables for option contracts for the months ahead. These include the strike price, market price of the stock, time to expiry, risk-free rate, and volatility.

The value of VIX indicates the expected percentage change in the Nifty 50 index. For instance, if the India VIX is at 11.8 and the Nifty 50 index is currently at 17,900, it means that the index is expected to go up or down by 11.8% from its current level over the next 12 months. Therefore, the Nifty 50 index could potentially range from 15,807 to 20,993 in the next 12 months. This is just the current expectation as reflected in options prices. If the VIX mean reverts, options prices can rise.

To get a more precise range for the next 30 days, you can use the following formula: (11.8/12) * 17,900. This gives us a range of +/- 640 points. Thus, the Nifty 50 index could potentially range from 17,260 to 18,540 in the next 30 days if the India VIX stays constant at 11.8.

Historical perspective

In recent times, the India VIX has been trading in the range of 10-15, which is a historically low value. A low India Vix value indirectly indicates that volatility is low, which leads to lower premiums for option sellers in India’s highly liquid options market. It also means that most of the bad news, such as the Russia-Ukraine war, the US Inflation, and the rate hikes, are already factored in, and the market has become more stable and predictable in the short term. Investors are happy as they can accumulate more stocks and not worry about the market crashing suddenly the next day.

A falling VIX is great for option sellers because they earn premiums on options they have written. However, for option buyers, the picture is not so rosy. Every time the VIX ticks lower, there is less chance for them to make money. The India VIX and Nifty have a negative correlation. When volatility spikes, the index goes down and vice-versa. However during times of extreme euphoria, the VIX can go up rather than down. This occurred once in 2014.However, in the aftermath of the victory of the National Democratic Alliance party led by current Prime Minister Narendra Modi, the VIX came down sharply. Volatility decreased but stocks continued to inch higher.

Option strategies

A long straddle is an options strategy that involves buying a call option and a put option at the same strike price and expiration date. In this strategy you do not take a directional view of whether the market will go up or down. You just take the view that there will be a sharp movement in some direction. The payoff for a long straddle is unlimited if the underlying asset price moves significantly in either direction, while the maximum loss is limited to the premiums paid for the options. The cost of making a long straddle has decreased by almost 40 % in the last one year due to a fall in volatility in the market. However it is difficult to predict when mean reversion will happen. Raj Deepak Singh, analyst—Derivatives, ICICI direct, said, “We do not recommend long straddle or strangles just in the anticipation of spike in VIX. Market hasn’t even spent two weeks in the current consolidation so far. Hence taking long volatility strategies in the anticipation of spike in VIX can be avoided."

Deepak Jasani, head of retail research, HDFC Securities, outlined another strategy “One effective strategy that we can deploy in a low-VIX scenario is the simple debit spread. This involves buying a call at a lower strike price (preferably at the money) and selling one at a higher strike price (out of the money, or OYM) simultaneously. The second leg (short OTM option) will further reduce the cost of the long option while limiting the profit potential. In a low-VIX environment, this strategy works particularly well because options premiums tend to be cheaper due to lower implied volatility levels. This means that you can enter into debit spreads with less capital than usual while still maintaining good risk management practices," he said.

What next?

“A period like this is great for stock pickers. You should buy good stocks and be patient. Returns are made in bull markets or bull trends in stocks and those will eventually come.", said Deepak Shenoy, founder and chief executive officer, CapitalMind. “This is also the best time to do a systematic investment plan (SIP). I’ve been saying this for a long time that SIP’s should be done in bear markets or sideways markets and not in trending markets. I mean, if you do dollar cost averaging when the market’s moving up, you are not getting the best deal. Dollar cost averaging works best when your when your time duration is much longer and that’s when it pays off.", said Tejas Khoday, co- founder and CEO—Fyers. Options trading is a high risk activity and a recent Sebi report showed that 89% of futures and options traders do not make profits. Long-term investors are better off patiently investing their money in the stock market through SIPs.

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