What is VIX?
VIX is a volatility index which measures the market’s expectation of volatility or price range over the near term. India VIX is a volatility benchmark based on the NIFTY Option prices. It measures the expected fluctuation in NIFTY over a period of 30 days. A higher the value of VIX means higher the fluctuations in either direction over the next 30 days.
How we can determine the price range of Nifty using VIX?
If India VIX is 24, it implies the price range of NIFTY for next 1 year will be between +24% and -24% from the current price. For example, If NIFTY is at 11000, then the expected price range of Nifty for 1 year is between 8360 and 13640. We can calculate expected volatility for a week using the formula VIX/Sqrt (365/n)). n will be 7 if we want to calculate for a week.
So, for a week, expected volatility will be [24 / Sqrt (365/7)] which is equal to 3.32%. So, the expected NIFTY price range for the week is between 10634 and 11366.
Does VIX have predictive power?
We have backtested using VIX and NIFTY50 data for the period of 5 years to know the efficacy of VIX in predicting the price range. Same as the above example, If VIX is at 24 and NIFTY is at 11000, then the expected range for NIFTY is 10634 and 11366. The price range for a week is calculated historically on a rolling basis.
When we checked the probability of week’s high and low falls within the projected price range. It comes at 57%. So, this number doesn’t seem to be exciting.
But when we checked, what is the probability of next week’s close falling within the projected price range and That comes to 77%. This number seems much better now. So, now we know NIFTY is expected to close within the projected price range 75 per cent of the time on a weekly basis.
How can we use this information to trade?
We can use it in many ways. Here we will show you a very basic way of using this information to take an Iron Condor strategy in the NIFTY weekly option contract. An Iron Condor is a covered credit spread strategy that benefits from the passage of time (theta) and decreases in implied volatility (Vega).
For example, on 6th August 2020, NIFTY is at 11200.15 and VIX is at 23.15. The projected price range for 1 week will be 10841 and 11559. Following position can be taken.
Sell 11500 Call 13/08/20 expiry: Rs. 18 approx.
Buy 11600 Call 13/08/20 expiry: Rs. 8 approx.
Sell 10900 Put 13/08/20 expiry: Rs. 28 approx.
Buy 10800 Put 13/08/20 expiry: Rs. 16 approx.
Net Credit: 22 Points
Max Reward: 22 Points
Max Risk: 78 Points
Risk reward ratio: 3.5:1
Breakeven points: 11522 (11500+22) and 10878 (10900-22) which is approximately our projected price range.
Nifty closed on 13th August at 11300 which is between 11500 and 10900. We would have made Rs 1650 (22 points) profit.
Can this be improved?
The answer is Yes.
- This trade can be taken only when there is a risk-reward ratio better than 2:1.
- We have predicted the volatility and not the direction of the market. Along with this if we use trend indicators, we can improve this trading methodology.
We think we have created enough interest for you to explore further. We left it open for investors for doing further research on this topic and add VIX to their trading arsenal.