Volatility Index is a measure of market’s expectation of volatility over the near term. Volatility is often described as the “rate and magnitude of changes in prices” and in finance often referred to as risk. Volatility Index is a measure, of the amount by which an underlying Index is expected to fluctuate, in the near term, (calculated as annualised volatility, denoted in percentage e.g. 20%) based on the order book of the underlying index options.
Volatility Index is a good indicator of the investors’ perception on how volatile markets are expected to be in the near term. Usually, during periods of market volatility, market moves steeply up or down and the volatility index tends to rise. As volatility subsides, option prices tend to decline, which in turn causes volatility index to decline.
Volatility Index offers great advantages in terms of trading, hedging and introducing derivative products on this index. Investors can use volatility index for various purposes as mentioned below:
* Investors’ portfolios are exposed to volatility of the market. Investors could hedge their portfolios against volatility with an off-setting position in India VIX futures or options contracts.
* Volatility index depicts the collective consensus of the market on the expected volatility and being contrarian in nature helps in predicting the direction. Investors therefore could appropriately use this information for taking trading positions.
* Investors could also use the implied volatility information given by the index, in identifying mis-priced options.
* Short sale positions could expose investors to directional risk. Derivatives on volatility index could help investors in safeguarding their positions and thus avoid systemic risk for the market.
* Based on the experience gained with the benchmark broad based index, sector specific volatility indices could be constructed to enable hedging by investors in those specific sectors.
CAclubindia
