11/09/2013
Analysis by MANASA CHOUDARY
Advantage VIX
The media in recent times is regularly reporting the weakness prevailing on bourses and the nervousness of the market players. One indicator that is referred to frequently in this context is India VIX or volatility Index.
VIX is popularly known as the fear gauge - a rise in VIX indicates low confidence level in the direction markets while a fall indicates high confidence level in the markets. When I cursorily looked up the historical VIX data, I noticed that average India VIX is on the rise since January 2013.The month wise average VIX for this year stood as follows:
Month VIX
January 13.87
February 15.50
March 15.00
April 15.64
May 17.14
June 18.67
Volatility Index measures the market expectations of near term volatility as reflected in the option prices. It is an index of the implied volatilities of out of the money call and put index options, here Nifty options. Implied Volatility (IV) is calculated by reengineering the option pricing models such as Black – Scholes option pricing formula. To calculate the IV of an option, the option price along with spot price, strike price, time to expiration and risk free rate of return is taken as given in the market. Then the formula is reworked to calculate the volatility
Option prices prevailing in the market differ from their fair values. The reason for this difference is the difference in historical volatility that is used for calculating the theoretical option prices and implied volatility that is factored-in in the market price of an option. While historical volatility reflects the past, implied volatility is an indicator of market expectations of the future movement of the index.
India VIX is a weighted average of the out of the money Nifty call and put options. If VIX stands at 15%, it indicates that the market players expect a move of 15% over the next one year. In other words it means that the index is expected to move 3.87% (25/√12) over a period of thirty days.
Interpretation of VIX
As said above, VIX is also termed as the fear gauge. A rise in VIX is seen as a reflection of wariness in the markets while a fall is interpreted as an increase in confidence of the market direction.
VIX like Put – Call Ratio can be used as a contrarian indicator. By a contrarian indicator we mean to say that though a rise in VIX can be on account of rising nervousness in the markets, it helps in identifying the possible levels at which one can assume fresh long positions in the market and also point the level at which one can exit.
Comprehensive research and analysis of the historical VIX data helped in identifying entry and exit levels without considering the Nifty index technical charts.
The Objective
To identify opportunities to assume positions in nifty options.
The Analysis
The VIX data from NSE was used for my Analysis. NSE provides historical India VIX data since 2 March 2009. While analyzing the data I observed that the VIX figures for the year 2009 were very high and were not in keeping with the data for the later years. This could be on account of lack of adequate depth in options market during 2009. Therefore, to avoid distortion, I considered data only from 1 January 2010.
VIX can be analyzed in two ways. One is by observing the actual level of the index and its effect on the markets and the other is by comparing its recent movements to its long term average. I used the latter to analyze the VIX.
Methodology
• After collecting the required data, I calculated the short term – 20 day EMA and long term exponential moving average – 100 day EMA.
• Then I studied the divergence between the EMAs i.e. the difference between 20 day EMA and 200 day EMA.
• As can be expected, the EMAs did not coincide. However, the area of interest here is the degree of divergence.
• When the divergence between the EMAs is small, no conclusion can be inferred. However, when the divergence exceeds a particular range certain conclusions can be drawn.
• When the divergence is more than 1 i.e. the 20 day EMA is more than 100 day EMA, it is time to buy or assume bullish positions. Towards this end, I sold out of the money put options.
Reasoning – the high VIX indicates the market traders’ preference to assume long positions in options thereby inflating the option premium which is reflected in the high IVs. To capitalize on this finding, we can assume short option positions. The short option positions will turn profitable once volatility returns to normal (volatility is mean reverting) and the option premiums too will reduce. Here I preferred to sell put options instead of call options as in cautious market environment, put options trade with high implied volatility packed-in in their premiums.
• When the divergence is beyond -1, i.e. the 20 day EMA is below the 100 day EMA, it is time to sell or assume bearish positions. For this, I sold out of the money call options.
Reasoning – the low VIX reflects low traders’ confidence in the markets in near term where long positions will be assumed in calls. In such a scenario, call options will be trading on high implied volatiles. Option traders can gain by selling the highly priced call options.
• Further, we also see that when the divergence is beyond -2 it is advantageous to assume long straddles or strangles.
Reasoning – in periods where the near term VIX EMA is significantly lower than its long term EMA, I tried assuming long straddles or strangles to capitalize on the mean reverting nature of volatility. However, the success rate as can be seen below is not encouraging. This is on account of high theta effect that overshadows the delta effect in long option positions.
• Contrarily, when the divergence exceeds 2, then it is time to sell straddles or strangles.
Reasoning- when the 20 day EMA rises significantly over the 100 day EMA it flags off a period of high volatility in the markets. Here assuming long volatile positions where we buy both calls and puts has paid off as can be seen in the table below.
While assuming positions, I kept a strict a watch on the divergence between the EMAs. For example, if after assuming a short put position divergence continues widening and exceeds 2, then I closed the short position and assumed a long volatile position and hold it till the divergence dips below 2.
Findings
Using the methodology described above I could identify 43 trading positions where one could assume positions in Nifty options without taking into account the technical supports and resistances. I achieved a success rate of 79% by assuming various positions in Nifty using historical data since January 2010.
Strategy Type → All Naked Short Calls Naked Short Puts Short Strangles/Strangles Long Strangles/Strangles
No. of Strategies 43 20 5 6 11
Correct 34 18 4 5 6
Wrong 9 2 1 1 5
Success Rate 79.07% 90.00% 80.00% 83.33% 54.55%
Live Testing
Based on the VIX moving averages I have assumed a short put position. The status of the same is as shown
Date Nifty Expiry Option Action Strike Entry Date Nifty CMP P/L
27.06.13 5682.50 25.07.13 Put Sell 5700 110 25.07.13 5907.5 0 110
Though the success rate using historical data is encouraging, I have to observe the efficacy of the model in identifying real time opportunities. Further, I considered only the end of the day VIX data for deciding points of entry and exit. However, VIX is calculated on a real time basis by NSE. Thus, during the trading hours the divergence can expand or shrink causing nervousness. Therefore it is very important to test this model on real time basis before using it for generating recommendations to clients. While I considered only 20 day and 100 day EMAs, it is worth testing other short term and long term EMAs too.
