VIX stands for Volatility Index , it is the measure of the prevailing volatility in the underlying index that it represents , different indexes throughout the world have their own VIX indexes , in India VIX is based on Nifty 50 and is called India VIX , likewise S&P 500 in USA has it’s own VIX called the S&P VIX which indicates the volatility in the S&P.
How is Volatility Index (VIX) calculated ?
VIX is a measure of market’s expected volatility over short term period. Volatility is often described as the “ rate and magnitude of changes in prices ” and in finance often referred to as risk . VIX is a measure of the value by which an underlying Index is expected to fluctuate in the short term, (calculated as annualized volatility, denoted in percentage e.g. 20%) based on the bid and ask prices of the underlying index options.
India VIX is a volatility index based on the NIFTY 50 Index Option prices. From the bid-ask prices of NIFTY Options contracts a volatility figure in percentage is calculated which indicates the anticipated market volatility over the next 30 days , in simple words it gives the annualized rate by which the index Nifty 50 can move in the next 30 days , for example if VIX is 20 right now then in the next 30 days it’s expected to move in either direction by an annualized rate of 20 percent.
How to use VIX or volatility Index in trading or investing –
VIX plays a significant role as it gives the investors as well as traders a yardstick to measure the bearish or bullish nature of the overall stock market , below are the 3 ways by which one can use VIX –
1. Negative or inverse correlation between VIX and the Index
There is a negative correlation between the volatility index and the underlying index it represents , that is if the underlying market in bullish in nature then the VIX will be bearish and vice versa , bullish markets always rise slow and steady and have their own minor corrections or pullbacks while bearish markets generally tumble like humpty dumpty , market always takes days or months to rise with slow pace but when the market comes into the grip of bears then all those months worth of gains can be lost in a few days or even in few hours in form of flash crashes , so bull market tends to have low volatility hence the VIX is low or is falling in such bull markets while in bear markets volatility is at its peak and so is VIX thus VIX rises in bear markets .
Above are the technical charts of VIX and Nifty 50 which clearly show the negative correlation between the underlying index and the volatility index , look at the solid marubozu candles that VIX chart made as the Nifty index started tumbling , Investors and traders must use the VIX in their strategies to make decisions , Investors can hedge their portfolios when VIX starts rising and traders can also start looking for shorting opportunities as the VIX starts climbing.
2. Using the 52 weeks high and low level of VIX
Another way that VIX can be used is that the current value of VIX can be compared to the 52 weeks high and low , if the VIX has bottomed out or is oversold and it has started to bounce off the 52 weeks lows then this can mean that a correction in the stock market may be due in the short term , this can be used by investors to book profits or to hedge their portfolio against any sharp fall in market , traders can use this to look for shorting opportunities in such cases.
Likewise if the VIX is at it’s 52 weeks high and has started to decline from it’s 52 weeks high it might mean that the market has bottomed out and might start showing bullish nature soon thus this can be a good opportunity for investors to look for fundamentally good stocks that have taken a beating in the bear market and are available at a cheap price for investment , traders can start looking for long opportunities in stocks or can look to buy index futures or monthly call options to benefit from the future rise of stock market index.
3. Using VIX together with BETA –
Apart from the ways VIX can used that are mentioned above there is an interesting way that VIX can be used by investors and swing traders / positional traders . When VIX has topped out or has bounced off the 52 weeks high it can be used to buy high BETA stocks by investors , swing traders can also look for high beta stocks with good technical buy setups , buying high BETA stocks will lead to good gains for both investors and traders as the stock market will be oversold and good fundamental stocks can be available at attractive valuations , if you are wondering what BETA is then read our article on BETA here and then come back and read point number 3 again.
Likewise when VIX has bottomed out or has bounced off from the 52 weeks low it can be used by investors to switch to low BETA stocks if they want to stay invested , by doing this they can save their portfolios from risky high BETA stocks that might be pulled down together with the whole stock market , traders in such scenarios can use the high BETA stocks as shorting opportunities and can sell on rise as per favorable technical setups.
Final Thoughts on Volatility Index (VIX) –
One should treat VIX just as one will treat any other technical indicator , in true sense it’s just an indicator , several times VIX can behave opposite to what it’s meant to be it can rise on a bullish day or fall on a bearish day , so take this with a pinch of salt don’t over depend or solely depend on the VIX , use it as an indicator in your investment or trading strategy , however good this might sound but every indicator has it’s own flaw’s hence over relying on VIX can be bad not just for your investing or trading career but also for you P&L.