On a closing basis, the Nifty 50 Index fell about 3 per cent last Monday, even as the India VIX (Volatility Index) jumped about 40 per cent. Small wonder then that the media focused on India VIX in their market report that day. This week, we discuss the relevance of VIX and how you can incorporate inferences from this index into your trading strategies.
Fear gauge
The VIX is referred to as a fear gauge. This is because the VIX, typically, increases when the equity market crashes and declines when the market moves up. This can be attributed to the high demand for put options when the market crashes. On a broader note, the more volatile a market is, the greater the demand for options. Why? Options have asymmetric pay-off. That is, long option positions allow you to participate in the directional movement of the underlying, and yet restrict your losses to the option premium. In contrast, a long futures position moves one-to-one with the underlying, thereby, exposing you to large losses when the market crashes. Suffice it to know that the India VIX, based on the VIX created by Cboe Global Markets, is based on the implied volatility of select strikes of calls and puts on the Nifty Index.
How should you use India VIX in your trading strategies? Given that VIX moves inversely with the equity market, it is tempting to conclude that an increase in VIX is an indicator of the market declining soon. But that kind of analysis may not always be useful. You should consider divergences in India VIX. Consider the Relative Strength Index (RSI) on India VIX. A negative divergence occurs when India VIX is at a high, but the RSI is showing a lower high. A positive divergence occurs when India VIX is at a low, but the RSI has formed a higher low.
A negative divergence on India VIX RSI can help you decide whether to close your short positions in futures or calls or long positions in puts. You could consider going long on calls as an aggressive entry. Note that a negative divergence on India VIX RSI means that volatility could come down in the near term. And that may indicate the stock market could form a bottom and reverse upwards. A positive divergence means you should consider closing your long positions in futures or calls or short positions in puts. You could also consider initiating long position in puts as an aggressive entry.
VIX-based strategy
To use India VIX in trading strategies, traders should consider divergences in the volatility index
Optional reading
VIX has been empirically found to be a better trading tool when the volatility index is compared to VIX futures contract. Typically, traders expect the S&P 500 Index to move up (down) when VIX futures trades at a discount (premium) to the VIX. It is important that you use VIX as an additional tool in line with the argument that you need a cluster of evidence as a trader to initiate options position.
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