Ever since Russia invaded Ukraine, we all have been hearing the term ‘volatility’ almost every other day! Financial newspapers have been carrying headlines such as, ‘volatility has gripped the stock markets’, ‘volatility raises its ugly head’, and so on.

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I’m sure you must have come across this term and pondered over its meaning or its impact on the stock markets. So, let’s decode the nitty-gritty of volatility and understand why it matters!  

We spoke to Sunil Bagaria, Director at Choice Equity Broking Private Limited on how investors should decode India VIX:

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In a freely traded market, all assets demonstrate volatility, which is simply the variability in price over any given time-period. The more dramatic the price fluctuations in an asset, the higher the level of volatility.

Financial markets are driven by two powerful emotions-greed and fear. At times ‘greed’ dominate the markets, while at times ‘fear’ is more dominant.

It is important for traders to assess general market sentiment before investing or trading in the market. This is where the Indian Volatility Index (VIX) comes into the picture.

It is a fear gauge and is widely used by experts to ascertain the market moods before making investment or trading decisions.

The India Volatility Index (VIX) is a real-time index that signifies the market’s expectation of future volatility of the stock market.

VIX is also known as the “Fear Index” simply because it helps to gauge how worried traders are that the benchmark Nifty might suddenly drop within the next 30 days.

Long Story short: It helps the equity and options traders to gauge the market’s anxiety level.

Understanding relationship of VIX with the market  

Digging deeper, when the VIX starts moving higher, it is telling you that traders are getting nervous. When the VIX starts moving lower, it is telling you that traders are gaining confidence.

So, for the most part India's VIX is inversely correlated to the market i.e., India's VIX tends to drop when the market goes up and vice versa.

Ideally, volatility has to stay below the 20-mark for calm and stability and brings conviction in the bulls’ camp who are aggressively long on the markets.

Alternatively, if VIX gives a value of greater than 30, then the market is seen as volatile.

Lastly, a VIX of 30 translates to implied volatility of 30% on the Nifty.

This means that the index has a 66.7% probability (or within one standard deviation) of trading within a range 30% higher or lower than its current level, over the next year.

Basically, if the Nifty is currently trading at 17,000, VIX is “implying” that over the next 12 months, its price will fluctuate between 11,900 and 22,100 (30% below and above 17,000).

Illustration that explains VIX is inversely correlated to the market
 
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As shown in the figure, VIX has a tendency to rise sharply when there is a fall in the market due to the unfavourable event or news flow such as the coronavirus pandemic fall which was witnessed in 2020.

On the other hand, a decline in VIX is a feast for the eyes of bulls. As shown in the figure, a decline in VIX resulted in a clear up-move in the market.

In a majority of the cases, we can see that relationship between India VIX and Nifty is inversely correlated, that being said, there are exceptions when the India VIX does not inversely correlate with market movements, for example, in the year 2019 during the general election India VIX jumped and at the same time market rallied owing to optimism that BJP government would return to power, but there was some uncertainty in the air, which resulted in a spike in volatility.

Prudent advice for the market participants to follow when the volatility is high!

Market participants can lower their position size when volatility is too high as this will help them to lower their risk.

Meanwhile, high volatility can be determined by the market participants using a 10-days or 20-days Average True Range (ATR) of the VIX. Hence, it matters to keep in touch with VIX.

(Disclaimer: The views/suggestions/advice expressed here in this article is solely by investment experts. Zee Business suggests its readers to consult with their investment advisers before making any financial decision.)