Before learning about VIX, let’s learn about volatility. Volatility in the security markets implies the tendency of the market to move aggressively and quickly in both directions. The Price movement can be a sharp rise or decline in a short time frame.
Volatility can be caused due to increase in uncertainties and contingencies in the market. The uncertainties can be a result of macroeconomic events, geopolitical tensions or pandemics. Any situation where the damage or the benefit of an event becomes difficult for the market to discount the price of the security causes an increase in the volatility in the market.
Volatility can also increase when the market is expecting good news such as positive regulations or positive monetary policy decisions.
How do we measure Volatility?
We use the VIX index to assess the volatility in the securities market. VIX stands for Volatility index, it is a measure of the expected volatility in the securities market by the investors.
If the VIX index rises, the volatility in the market goes up. When the VIX goes down, the volatility goes down. A decreasing VIX implies less movement in the market, and low volatility can be implied as the market remains range bound in a narrow price range.
The highest recorded VIX for Nifty has been 86.63 on 24 march 2020 when the market crashed due to the covid-19, pandemic. Also, the lowest recorded VIX has been in the range of 8-10, after which the market has shown a steep decline.
Whenever the volatility has shown a sharp spike, the indices have shown downward movement and when volatility has dropped sharply, the market has shown a positive momentum. Although this trend has been consistent, it doesn’t guarantee a continuation of such a trend every time in the future.
Over the years, VIX has garnered significance as a metric for investors before entering a market or making exits.
The VIX has also been used by investors to predict trend reversals, as shown in the chart below. The VIX index has formed an inverse pattern on the graph against the Nifty 50 over the past period. However and extremely low or high
High volatility offers good opportunities to option buyers, who can take advantage of the big margins of movement in either direction.
It poses a big risk to the options sellers who are forced to add more margins due to short-term spikes or drops in the price of the security.
Volatility implies big short-term profits for intraday traders but also a big stop-loss and losses to the traders. It is a common occurrence for investors in a volatile market to succumb to short-term volatility and liquidate their positions while the security eventually reaches its target price.
Thus, an investor’s survival depends on how well you manage the volatility to save his capital from sharp short-term price movements.