Wednesday, February 12, 2014

Understanding the Basics for Trading VIX in India

National Stock Exchange of India Limited (NSE) is all set to launch trading on Volatility Index Futures (VIX) from 26th Feb, 2014.

Let us discuss about VIX Futures, Its trading, Advantages and  Lacunae(If any).

The Circulars pertaining to launch, Contract Specification and Settlement are (here),(here).

What is VIX ?

VIX  was launched on CBOE and it is their trademark (here). In India Volatility index(VIX) is a measure of Implied volatility on Nifty Options or we can say it the expectation of volatility for next 30 day. VIX is always calculated for next 30 day only.

VIX is calculated using Implied volatility (IV) of all out of money calls and Puts of Near month and Mid month of Nifty. To know more about computation methodology Refer (here), (here),(here).

Simply, VIX would be one number, which will help us look at the expected market volatility / Nifty volatility  for next 30 day. Eg: If there is budget / Result season next month, we can expect that number to be higher, as the market will be more volatile.

Can we trade on VIX ? Also some more details ?

Yes, We can trade in VIX futures in India. It will be available for trading on derivatives segment of NSE from 26th Feb, 2014. The Lot size of VIX will be minimum Rs 1 Million. VIX will be traded on derivatives segment of NSE. The contracts will have weekly settlement and there will be 3 weekly contracts available for trading. Effectively you can take a view of IV for 30 day after 21 days.

The final settlement of the contracts will be Tuesday's (I guess on other days, there can be impact of bias in IV, like on Friday late session, the IV tend to fall because of Theta value of weekend etc). The final settlement of VIX contract will take place on average VIX price of last 30 minutes of trading on Tuesday.

The Contracts are cash settled and the settlement will take place on T+1 basis, along with other derivatives contract. Also Spread contracts will be available for rollover.

The Margins on VIX futures would be at least 15% , But I believe it will be more (Up to 20% to 22%) because of volatile nature of VIX Futures. Also the benefit of spread margin will be available on VIX futures.

Also STT is also applicable on VIX futures, which will be same applied on Index Futures

What is the Use of VIX ?

a) VIX is used as a single number to predict the expected volatility for next 30 days.

b) It can be the tool for hedging.

c) It can be a volatile product to trade.

d) It also has predictive power on expected volatility

e) Historically It has negative co-relation with nifty futures. So If Nifty goes up, VIX tends to fall and vice versa.

f) Arbitrage is also possible both covered and Statistical.

How do we trade on VIX Futures?

a) Speculation : A Person can take a view on expected volatility and trade based on it ,Beware It will be very volatile, at least 5% a day.

b) Hedge : A Portfolio investor can hedge his portfolio by buying VIX (Inverse relationship)

c) An Investor can take position on VIX based on his Option Portfolio. He can hedge his gamma 

d) VIX futures is helpful in volatile times as you can take view on VIX, as VIX futures does not suffer decay (Theta)

e) An Arbitrageur can also indulge in spread trading on VIX futures.

What are the USP of VIX Futures?

a) There is higher volatility in VIX compared to VIX itself, Hence It is a volatile product which may lure traders.

b) Institution Investor are interested in VIX as a hedge, Thereby creating depth in market.

c) Cash Settled.

d) The computation of VIX is shown on NSE screen, every second.

Is there any Shortcomings / Lacunae in VIX Futures ?

a) It is very volatile product. On a single day, there will be moment of at least 5%, means a person can gain/ lose Rs 50,000/- in a day in 1 lot.

b) The Life of contract is very small only 21 days.

c) The expiration of VIX futures and Index Futures do not fall on same day, hence a difficult arbitrage.

d) Rollover will be very expensive as you will have to pay STT every week.

All in all , VIX is a new product to trade, but It is not meant for soft-hearted people. I feel that VIX futures will be Restructured in future to get broader participation. Also the Life of VIX futures needs to be increased. 

Also note that VIX Index or Implied volatility is always higher than realised volatility in normal times.

This is not a recommendation to anybody whatsoever to buy OR sell this share, but it is my thought process and views on this topic.

I welcome your critical comments and suggestions.