In this article, I am going to discuss the relation between the volatility index (VIX) and the options pricing. If you are aware of the Black Scholes model of options pricing, the call and put options pricing is dependent on following factors –
1) Price of the underlying
2) Strike price
3) Risk free rate of interest
4) Time to expiry
Out of these five factors, first four are factual in nature. You know the price of the underlying, strike price, risk free rate of interest, time to expiry at the time of writing an option. What you don’t know is the volatility in the near future and thus it is somewhat subjective in nature and derives from the anxiety or fear of the option writer. This volatility is called implied volatility and it reflects the sentiment of a option writer. If the option writer thinks that in the near future the volatility is going to be high, he would demand higher premium for writing an option and thus the prices of the options will be higher. On the other hand if he thinks the volatility is going to be lower, he will demand lesser premium for the options and thus lower option prices.
Now if we consider all the option writers present in the market. There would be millions of such people and if we try to calculate the average volatility from the options they have written, we can get a value which can describe the overall sentiments of the market about volatility. This is what Volatility Index really tells us. It uses the prices of the options to guess the future volatility, ofcourse, after doing several other operations as well but in a nutshell, it is the reverse process of option pricing taken all the options being traded into account and thus calculating the sentiment of the entire market. You can read the exact method of calculating India VIX here.
Now what does a particular value of the India VIX indicates? The value of India VIX at the time of writing this article is 19.63 which means people are thinking that over the next 30 days markets can move up or down by 5.67% [19.63 divided by square root of 12] and demanding premium as per this value. Low value of VIX indicates stability in the market while higher value indicated stress, fear and anxiety. Since, the investors are more fearful of the downside, VIX is negatively correlated to the stock market index like Nifty or Sensex which means as the market index drops the VIX value increases and vice-versa. I will soon post another article, discussing the correlation between India VIX and Nifty and how VIX can be used as a hedging tool once India VIX futures and options are introduced.