A 'volatility' index in India adapting Chicago model (Comment: Special to IANS)

The Oracle of Omaha Warren Buffet once said participants should treat market fluctuations as a friend rather than an enemy. Indian investors will now have a product to do just that.

The National Stock Exchange (NSE) is introducing the VIX futures (volatility index with contract symbol of IndiaViX) Feb 26. This derivative can be used by both hedgers who can protect the risks of their equity portfolios and speculators who can take outright directional bets on the expected near-term volatility.

The volatility index is also known as the "fear index" in the Western markets. It was first launched by the Chicago Board Options Exchange (CBOE) in 1993. Although the pricing of VIX is relatively complex and involves a deep understanding of implied volatility and the options market, the underlying trading idea is quite basic.

The VIX shows the markets expectation of the next 30-day volatility. Higher the India VIX reading, the more volatility market participants are expecting and vice-versa. If investors are expecting large sideways movement in equity indexes, such as the S&P 500 or the Nifty, one trading strategy could be to go long on VIX futures.

VIX values of greater than 30 are generally associated with large amount of volatility as a result of investor fear and uncertainty in the markets, while readings below 20 signify calmer or less-stressful times in the market, going forward. However, these levels should not be used as a rule of thumb while trading.

At the peak of the turmoil during the financial crisis of 2008, the US VIX had hit an all time high of 80. However, during the debt ceiling (fiscal cliff) debate over two years ago, the US VIX stood below 20.

The success of VIX futures in India would be determined by its liquidity. Over time, efforts must be made by the NSE and other exchanges thatv wish to launch the product in the future, to educate the retail investor about the advantages of trading on this product and shore up the trading volumes.

Further, NSE should also look to introduce a VIX options contract soon. Most fund managers in US and Europe do not take positions in outright VIX futures to hedge their portfolios but prefer buying VIX puts or calls as per their strategy. Option contracts, limit an investors downside after having paid a premium.

Although, trading in VIX will begin only Wednesday, NSE has been giving out India VIX data since March 2009. For 2014, the India VIX has been range bound. It closed at 15.88 on the first trading day of 2014 and ended at 14.04 last Friday as per NSE data. The India VIX and the Nifty should ideally display a strong level of negative correlation. On days of deep market correction, one can expect the VIX to move up sharply.

The timing of the introduction of this product could not have been better. With the general elections due in May, Indian equities are more likely to exhibit volatile moves as they were in the build up to the 2009 polls. Assuming a "Modi" rally (on the prospects of Bharatiya Janata Party's prime ministerial candidate, Narendra Modi) does not take place, one can now go long the VIX.

(Vatsal Srivastava is a senior market analyst. The views expressed are personal. He can be contacted at vatsal.sriv@gmail.com)