Understanding Implied volatility

ABOUT VOLATILITY INDEX

Volatility index or VIX, also called the "fear index" or "risk index," is an indicator that captures the level of fear in the capital markets and help investors understand market risks better and take decisions accordingly. When investors turn fearful, the VIX index moves higher. The Chicago Board Options Exchange (CBOE) was the first to develop volatility index in 1993. There is also the VXN which tracks the Nasdaq and VXD that tracks the Dow Jones Industrial Average.

The implied volatility, as captured by the volatility index, is not about the size of the price swings, but rather the implied risks associated with the stock markets.

Implied volatility increases when the market is bearish and decreases when the market is bullish. This is due to the common belief that bearish markets are more risky than bullish markets.

Market volatility keeps changing as new information flows into the market. High readings indicate a higher risk in the market place. For instance, the reading of VIX reached almost 45 in 1998 as the LTCM (Long-term Capital Management) crisis exploded. It took a few months for the investor's fears to abate and the VIX to return to below 20. The World Trade Center attack in 2001 also made the VIX climb above 45, as the investors' fear level reached the zenith.

India VIX is a volatility index based on the Nifty 50 Index Option prices. It uses the same methodology that CBOE uses to compute its VIX, which is based on the prices of options of the S&P 500 index. From the best bid/ask prices of Nifty 50 options contracts (which are traded on the F&O segment of the NSE), a volatility figure percentage is calculated, which indicates the expected market volatility over the next 30 calendar days.

Higher the implied volatility, higher the India VIX value and vice versa. There are some differences between a price index, such as the Nifty 50 and India VIX. Nifty 50 is calculated based on the price movement of the underlying 50 stocks, which comprises the index. India VIX is calculated based on the bid-offer prices of the near- and mid-month Nifty 50 Index Options.

While Nifty 50 signifies how the markets have moved directionally, India VIX indicates the expected near-term volatility and how the volatility is changing from time to time.

It has been observed that when the market is range bound or has a mild upside bias, volatility is globally observed to be typically low. On such days, investors prefer buying call options (a position taken on the view that the market will move higher) over put options buying (a position taken on the view that the market will move lower). This kind of market may indicate lower risk.

Conversely, when the selling activity increases significantly, anxiety among investors tends to rise. Investors rush to buy puts, which in turn pushes the price of these options higher. This increased price that investors are willing to pay for put options shows up in higher readings on volatility index.

At present, NSE will publish only the index values at the end of the day. Once there is stabilization, products based on India VIX will also be launched.

India Volatility Index Vs Nifty 2009
Date	VIX Close	NIFTY Close
01-Jan-09	41.34	3033.45
02-Jan-09	40.67	3046.75
05-Jan-09	38.6	3121.45
06-Jan-09	38.73	3112.8
07-Jan-09	44.36	2920.4
09-Jan-09	47.82	2873
12-Jan-09	48.57	2773.1
13-Jan-09	53.47	2744.95
14-Jan-09	44.26	2835.3
15-Jan-09	45.17	2736.7
16-Jan-09	44.3	2828.45
19-Jan-09	44.46	2846.2
20-Jan-09	45	2796.6
21-Jan-09	45.41	2706.15
22-Jan-09	45.55	2713.8
23-Jan-09	34.01	2678.55
27-Jan-09	42.86	2771.35
28-Jan-09	40.76	2849.5
29-Jan-09	43.11	2823.95
30-Jan-09	42.1	2874.8
02-Feb-09	43.69	2766.65
03-Feb-09	49.24	2783.9
04-Feb-09	44.39	2803.05
05-Feb-09	43.92	2780.05
06-Feb-09	50.65	2843.1
09-Feb-09	44.58	2919.9
10-Feb-09	44.3	2934.5
11-Feb-09	46.65	2925.7
12-Feb-09	45.65	2893.05
13-Feb-09	43.31	2948.35
16-Feb-09	42.56	2848.5
17-Feb-09	44	2770.5
18-Feb-09	43.04	2776.15
19-Feb-09	42.91	2789.35
20-Feb-09	45.21	2736.45
24-Feb-09	45.2	2733.9
25-Feb-09	41.94	2762.5
26-Feb-09	39.87	2785.65
27-Feb-09	40.61	2763.65
02-Mar-09	43.36	2674.6
03-Mar-09	44.44	2622.4
04-Mar-09	42.77	2645.2
05-Mar-09	41.56	2576.7
06-Mar-09	37.97	2620.15
09-Mar-09	41.03	2573.15
12-Mar-09	39.38	2617.45
13-Mar-09	35.57	2719.25
16-Mar-09	36.64	2777.25
17-Mar-09	38.47	2757.45
18-Mar-09	38.19	2794.7
19-Mar-09	35.98	2807.15
20-Mar-09	34.86	2807.05
23-Mar-09	37.63	2939.9
24-Mar-09	36.85	2938.7
25-Mar-09	28.18	2984.35
26-Mar-09	36.93	3082.25
27-Mar-09	37.14	3108.65
30-Mar-09	40.25	2978.15
31-Mar-09	39.48	3020.95
01-Apr-09	36.53	3060.35
02-Apr-09	37.4	3211.05
06-Apr-09	41.72	3256.6
08-Apr-09	43.55	3342.95
09-Apr-09	43.54	3342.05
13-Apr-09	46.56	3382.6
15-Apr-09	48.02	3484.15
16-Apr-09	50.51	3369.5
17-Apr-09	50.8	3384.4
20-Apr-09	54.22	3377.1
21-Apr-09	53.64	3365.3
22-Apr-09	57.88	3330.3
23-Apr-09	51.3	3423.7
24-Apr-09	47.78	3480.75
27-Apr-09	49.43	3470
28-Apr-09	48.8	3362.35
29-Apr-09	46.63	3473.95
04-May-09	49.54	3654
05-May-09	50.53	3661.9

So in the above chart we can see that when the Nifty close increases then the VIX value decreases and when the Nifty close decreses then VIX value increases.

I hope this article will help in understanding the impact of the implied volatility.

Happy investing