What is the Volatility Index and what does it indicate? How is it different from other market indices?

The Volatility Index (VIX) is an indicator of the market mood in the short term. It is a widely used measure of market risk and is constructed by using the prices of Nifty options (puts and calls). The India VIX was launched by the National Stock Exchange (NSE) in April 2008.

The VIX value is the percentage by which investors expect the markets to move in the next 30 days. So, if the VIX is at 30, investors are expecting the markets to change by 30%.

The VIX is different from other market indices because it is a forward-looking index. The Nifty, Sensex and other market barometers are price indices. Their values reflect the prices of the stocks in these indices. For instance, the Nifty closed on 19 February at 2,789.35 point, up 13.20 points or 0.48% from the previous closing. This level of the Nifty reflected the prices and market capitalisations of the 50 shares in the index.

On the other hand, the VIX tries to capture the market sentiment that is likely to prevail over the next 30 days by using the prices of Nifty derivatives. The VIX value for 19 February was 42.00 which means investors expect the Nifty to move 42% by 19 March.

Inverse relationship
The VIX has an inverse relationship with the market. When the markets tanked in the last week of October 2008 and the Nifty fell by almost 500 points in two days, the VIX shot up from 45% to 70% . So, the VIX goes up as the market becomes fearful and falls when the market feels confident about its future direction. This is because option prices tend to rise when investors expect the markets to be volatile and this pushes up the VIX. On the other hand, if investors don’t expect the markets to move very sharply, the prices of index options decline, bringing down the VIX.

Contra indicator
for contrarian investors, the VIX provides important clues to the future direction of the market. A high VIX value of over 50 indicates a high degree of panic in the market, which is seen by the contrarians as the best time to buy. On the other hand, a low VIX value of less than 30 suggests that the market will be range-bound and there is complacency among investors. Contrarians generally see this as an opportunity to short-sell.

Volatility futures
While most other indices have derivatives that can be bought and sold, there are no tradable products based on the India VIX. The NSE wants the market participants to first understand the concept of the India VIX and what it signifies before any derivative product is launched.