All over the world especially the US, volatility trading is very popular. Its has a lot of benefits. For example if you have a big portfolio of stocks and you feel the stock markets in general may head south (going down) and the volatility will increase, you can buy the volatility futures. In that way if it increases, you can make money.
What is Volatility:
Well volatility is nothing but the “fear factor” in the market. If there is a lot of fear, like a war going on, or some kind of big news coming the volatility usually goes up. If there is any kind of uncertainty in the markets, in the country of the stock market or the world itself (like war between two countries, big bank declaring bankruptcy or any country’s economy showing signs of recession etc), the fear factor will increase.
If fear factor (the risk factor actually – the risk of investing in the stock market) increases, the volatility will reflect that. If volatility increases the option prices – calls and puts – both will increase. If volatility decreases the option prices – calls and puts – both will decrease.
It should be quite obvious now that since most of these are bad news, the fear factor increases and the markets tumble. During normal times volatility calms down and stays in a range.
You can get the current India volatility also known as India VIX here:
http://www.moneycontrol.com/indian-indices/india-vix-36.html
Note: Sometimes the volatility may increase even if the markets are going up. For instance the recent general election in May 2014. Up to the election results’ dates the volatility just kept increasing. WHY? Because the markets had no idea which government will come to power. This was a big news. There was an uncertainty in the markets. Whenever there is an uncertainty the volatility will increase.
Since the market was hoping that BJP will come to power, it was going up – but fear was also increasing day by day – so the volatility was also increasing.
But in most cases, the markets and volatility go in opposite direction. In the US, you can also trade options on volatility. There the traders buy call/sell puts if they think the markets will fall and volatility will increase. If that happens their portfolios worth goes down, but they recover some money from the volatility calls bought or sold puts.
A 10% jump in volatility is very normal if the news is bad. Since it is leverage, the traders make good money.
It was a long demand of the market participants in India to bring in the volatility trading.
In Feb 2014 Nifty introduced volatility trading in their platform and officially the first day of NVIX trading was on 26-Feb-2014. Right now only futures can be traded. After some time they plan to introduce option trading on volatility too. I am eagerly waiting for that. 🙂
Here are some of the contract specifications taken from http://www.nseindia.com/:
Underlying: India VIX Index
Symbol: INDIAVIX
Futures name: NVIX (not Nifty VIX Futures)
Can be traded on: NSE
Instrument Type: FUTIVX
Lot Size: 550 (Revised on circular dated June 24, 2014)
Quotation Price: India VIX Index * 100 (means if VIX is 15.56 the quote will be 15.56 * 100 = 1556)
Contract Value: Minimum Rs. 10 lakhs at the time of introduction
Tick Size: Rs.0.25
Trading Hours: 9:15 AM to 3:30 pm
Expiry Date: Every Tuesday of the week
Contract Cycle: Weekly – 3 contracts
Contracts: Near, Mid & Far
Final Settlement Procedure: Cash Settlement
Final Settlement day: All open positions on expiry date shall be settled on the next working day of the expiry date (T+1)
How does this help option traders in India?
If you are an option buyer, volatility is your friend. But if you feel that volatility may decrease, your option prices may decrease in value. So you can sell NVIX. In that case if volatility decreases, you will make a loss in the options bought but will make a profit in the NVIX sold.
Similarly if you are an option seller, volatility is your enemy. If it increases, your options will also increase in value and you will be making a loss.
In that case an option seller can buy the NVIX futures. If volatility increases, you can make a profit in the NVIX futures, but you may make a loss in the options sold.
Important Disclaimer: Please remember that inverse may also happen. For example you bought a call option and sold NVIX. It can happen that volatility may increase and the index also falls very fast. In that case you will be losing money in both the NVIX futures and the calls bought. Why? Because the volatility is co-related to Nifty. You have bought a call and Nifty is falling – upto a certain extend the volatility increase may help, but if the fall is steep no volatility can help you. To some extend it may, but for that to happen the volatility will have to explode – increase by a huge percentage points. Under normal circumstances that rarely happens. You may lose money in both NVIX and calls bought. Trade with caution. You are better off buying a debit spread.
I am big fan of conservative trading. All my positions are properly hedged. This is one hedge position in my view not a great hedge. If there is a possibility that I will lose money in both the positions, I run miles away from that trade.
However just for reference I am writing here trades that can be done as hedging your options portfolio with NVIX:
Call Option Buy : Sell NVIX
Put Option Buy: Sell NVIX
Call Option Sell: Buy NVIX
Put Option Sell: Buy NVIX
Credit Spreads: Buy NVIX
Debit Spreads: Sell NVIX
Iron Condors: Buy NVIX
Investors can also straight buy/sell NVIX if they have a view. For example if an important news is awaited, you can buy NVIX, and on the day of the news before the news declared, book your profits and then sell NVIX.
Caution: Timing is not that easy.
Lets see how much risky is NVIX trading:
NVIX Futures price is the current volatility * 100 + some premium.
For example if the volatility is 18.1325
18.1325 * 100 = 1813.25 + 1.5 premium (approx) = 1814.75
Lot size is 550 = 1814.75 * 550 = 9,98,112.50
Ticker size is: 0.25 (If volatility increase by 1 ticker it is equal to 0.0025 and NVIX will then increase by 0.25 (0.0025 * 100))
Lets suppose volatility increased by 0.0025. So NVIX also increased by 0.25.
= (1814.75+0.25) * 550 = 9,98,250.00
Lets check the difference:
9,98,250 – 9,98,112.50 = 137.50
You can also get this figure by: 550 * 0.25 = 137.50
Which means for every ticker move a trader makes or loses 137.50.
Please note that lot size can differ from time to time. NSE will release the circular when the lot size will change. Currently lot size of NVIX is 550.
How volatility is calculated?
Its a complex mathematical formula. But in short it is computed by NSE based on the order book of options. All options and not just Nifty options.
Only near and next months bid and ask quotes are taken. If there is too much of sudden demand of options, VIX increases. If everything is normal VIX will reduce. The VIX that you see is the perception of the markets for the next 30 days.
When the VIX is high you will see that markets will have wild swings. It will go up and/or come down swiftly. During these times it gets very difficult to predict market direction.
When the VIX is high, most traders sell options. When its low they buy it. But today you can make more money by selling VIX futures if you think the volatility will calm down, and buying it if you think it will go up.
Some other important things on volatility:
1. VIX has a strong co-relation to Nifty movements. If Nifty falls, VIX increases and vice-versa.
2. India Vix has a mean of 26.65 and a median of 23.83. VIX reverts to mean, so option traders can make a note of it.
3. VIX is always expressed in percentage terms. It can never be lower than 0 or greater than 100.
4. Its easier to predict volatility. For example if a news is pending the volatility will increase until the news is out. Buy before news, sell after it.
5. You will need around 2 lakhs rupees as margin to buy/sell VIX Futures. Most retail traders do not trade VIX futures. One lot value is almost 10 Lakhs. But if your prediction is right, you can make amazing returns. However losses can also be huge.
Disclosure: In full disclosure I have never traded NVIX (VIX Futures). Although I have the intention to trade VIX options if they are introduced in India. This article is written for people interested in trading VIX. I am a conservative trader and am happy trading Nifty options. I like to take small profits and small manageable losses. Please use your own discretion before trading VIX Futures.
Some important references:
http://www.nseindia.com/content/indices/India_VIX_Brochure.pdf
http://www.nseindia.com/content/circulars/FAOP25802.pdf
http://zerodha.com/z-connect/queries/stock-and-fo-queries/trading-india-vix-simplified
http://www.business-standard.com/article/markets/10-things-to-know-about-india-vix-futures-114022600305_1.html
http://www.moneycontrol.com/news/market-news/how-will-vix-futures-work-iisl-answers_1045014.html
http://www.moneycontrol.com/news/market-news/tradingvix-futures-to-kick-off-tomorrow_1047948.html
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Very informative.!!! Very true that Volatility I’d very important factor for trading Options.All the Best. Keep writing …..:)
Thank You Abhishek. I know you read almost all articles here. Thanks again for being a regular visitor. 🙂