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Volatility and Skew

What is volatility in the context of the stock markets?

We often read in the newspapers or watch in news channels about Sensex and Nifty going up and down. Headlines such as “Sensex in the red” or “Nifty in the green” are common. Since the market’s movements are driven by the changes in stock prices, the ups and downs are a natural part of the process. But when these ups and downs happen too frequently, the markets are termed as volatile. In technical terms, according to Investopedia, “volatility is a statistical measure of the dispersion of returns for a given security or market index.” Volatility is associated with big swings in either the positive or negative direction of the markets. Volatility in the stock market is also associated with risks. Investments risks increase with increased volatility in the stock markets. This risk can be interpreted in two ways--risks can result in losses but risky instruments can also generate higher returns.

What causes stock market volatility?

Stock market volatility is inevitable. Since the companies that are listed on stock exchanges run businesses, they are bound to have good as well as bad phases. Fortunes of companies can change overnight because of unforeseen events like government regulations, management changes or natural calamities. Such changes, when they affect a large number of companies, lead to market volatility. Global events can also affect the stock markets in India since the Indian economy is linked to other economies around the world. For example, the rupee depreciating against the US dollar can affect a number of export-oriented businesses in IT and pharma. This can lead to the stock prices of these companies going down and hence, market volatility. What is important to remember for investors is that market volatility is a part and parcel of investing in equities. While volatility cannot be avoided, it can be mitigated through diversification across sectors and market cap.

How is volatility measured? What is the VIX index?

In India, one of the ways of measuring stock market volatility is by using an index called India VIX. This is a volatility index based on Nifty index option prices. According to the official NSE website, India VIX calculates a volatility figure in percentage terms from the best bid-ask prices of Nifty Options contracts. The index indicates the expected market volatility over the coming 30 calendar days. A high index value indicates higher volatility.

How is the VIX index used to measure volatility?

The India VIX index is used to measure volatility that can be expected in the stock markets. The higher the value, the higher the chances of the markets being volatile in the coming month. India VIX uses the computation of the Chicago Board Options Exchange (CBOE) with suitable amendments to adapt to the Nifty options order book. As per the official NSE document, the index uses the following factors in its computation: Time of expiry Interest rate Forward index level Bid-ask quotes While the computation is done, the index separately computes the variance for the near and mid-month expiry and uses them to get a single variance value. The square root of this variance value is multiplied by 100 to arrive at the India VIX index.

Who runs the VIX index?

In India, the India VIX index is run by the National Stock Exchange (NSE).

How can the VIX index be checked daily?

The India VIX index can be checked in real time during market hours on the NSE website.

How does MMI change in relation to change in the VX index?

The Market Mood Index (MMI) uses the India VIX index to measure expected volatility in the stock markets. A high VIX value indicates that higher volatility is expected. When clubbed with the other MMI components, the India VIX value influences MMI movement between the greed and fear zones.

What is skew in the stock markets?

The dictionary definition of “skew” as a noun says that it is “a slant or a bias towards one particular subject.” In the context of the stock markets, skew tells us the direction in which the market is expected to move. Skew is typically used along with the VIX index, which is a depiction of the volatility that is expected in the stock markets. The VIX index tells us how volatile the markets can be and skew tells us the direction in which the markets could go.

How is skew measured for the stock markets?

Since skew is used to measure the expectations around the market direction, it is calculated as the difference between implied volatilities of OTM put options and OTM call options of Nifty. Out of the Money (OTM) is an option that is worthless if exercised today. According to InvestingAnswers, an OTM call option has no intrinsic value because the current price of the underlying stock is less than the option strike price. Similarly, the OTM put option is considered out of the money when the price of the underlying stock is higher than the option strike price.

How does skew affect the MMI index?

A higher average value of skew represents a high chance of downward movement. Hence, it is likely that the Market Mood Index would move into the fear zone when the average value of skew is higher.