Computation method behind India's Volatility index's recent jump

The India Vix jumped up by another 9% on Tuesday, taking its value to 31.88. It is fast approaching the 52-week closing high of 32.5. Though a small part of this jump is because of the fear in the market, a major part is because of the way India Vix is computed.

"The jump is mostly because of its computation method and not because of the jump in implied volatility," says Bhavin Desai, derivatives analyst, Motilal Oswal Securities. It is computed as the expected volatility for a constant period of 30 days by taking the weighted average between two monthly series - current month and next month.

As the days progress, the current month weight reduces and the next month's increases.

While the April series is relatively less volatile, May series has high implied volatility due to the upcoming event, (ie, election results on May 16). "The market may gap up if Modi comes to power, else it may gap down," says Anil Manghnani, a technical analyst.

Since there will be major movement on either side on the results day, investors are taking extra precautions. Since the weight of the highly volatile May series will increase, India Vix will also climb up, provided the implied volatility of both months remains constant. And India Vix may also fall due to the same computational issues in the next series on April 25 because the implied volatility in June is expected to be lower compared to May because the major event will already be over.

While the broader market is scared by the climb of India Vix, "greedy speculators" are making money by trading on India Vix futures on NSE. Since the implied volatility will come down significantly post election, traders can also sell India Vix in the beginning of the new series and make money by participating in its downward journey.

India Vix futures are also quoting at significant premium to underlying value and this gives short sellers of the futures additional kicker when the expected fall happens.

But, a word of caution: First, a contract size is 750 with price ofRs 3,885. Hence, the value of each trade will be around Rs 29 lakh. It may, therefore, not be suitable for retail investors. Second, India Vix is extremely volatile. One cannot rule out a spike after the futures are sold.

This article taken from Economic Times :

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