Wednesday, April 09, 2008

This VIX will give you headache instead

Remember Vicks? The balm that is normally used when we catch cold? Now NSE launches VIX - a volatility index reflecting the market’s implied volatility (IV) 30 days ahead. It captures the IV embedded in options prices of stocks included in the Nifty 50 Index.

Thirty days IV is calculated from the best bid-ask price of Options contracts. Higher the implied volatility, higher the India VIX.

What is arguable here is IV as captured by VIX refers to the “implied Value at Risk” (I-VAR) (maximum possible loss) associated with the stock markets and not the size of the price swings. When the market is range bound or has a mild upside bias, volatility will be typically low.

But what it doesn’t say is that IV and VAR indicators are statistical probabilities and are highly questionable. They are not the outcome itself, they are indicative of likely outcomes. Seasoned market players do look at these indicators, but certainly would not swear by their effectiveness and applicability. Option pricing itself is fraught with several abstractions and infirmities, so you can imagine the level of arbitrariness that will go into its derivative indices like VIX.

One word – Avoid. Reason – even its authors don’t fully understand its ultimate impact – no safety nets yet. Gainer will only be NSE that charges a brokerage, no matter you win or lose.

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