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| P R Sundar, Aditya Trading Solutions |
Time: 7 pm
Understanding Stock Marker 1:
Every week I intend to write an article about stock market.
The aim is to help people to understand the factors affecting stock market.
Today I am taking the topic "Volatility"
What is volatility?
By definition, volatility means variation in price movements.
Prices will move up and down unpredictably and the move will be fast and furious.
Usually traders will be losing both sides of the market as they always keep stop losses.
NSE calculates volatility on a live basis using the option premiums.
Volatility index is known as 'VIX'
If volatility index is below 15, then the market will be a bull market.
Although violent market movement is what VIX represents, usually violent market movements will be on the downside rather than upside. So when the VIX is very high, then the market will be in a falling mode.
But usually the fall will not be linear as many traders will go short, then some good news comes, short covering will happen then another set of people will come and short and those who failed to exit will also exit during the short covering and hence market will fall again.
This why market moves both ways and eventually markets will fall.
During 2008 crisis, VIX shot up more than 80%.
The crisis of 2008 is one exceptional case.
Other than this usually VIX will trade between 10 and 35.
Then how to play the market when the VIX is very high?
When the VIX is high, it is better to be away from the market for traders. Usually high VIX period will not last long. May be 4 to 8 weeks.
There are strategies to make money even during high VIX period.
On 3rd May, the Nifty index was around 5950, the VIX was around 15. Take about thousand points up and down. December 2013 expiry, 5000 Put option was trading at Rs 52 and 7000 Call option was trading at Rs 43. So total premium works out to be Rs 52 + Rs 43 = Rs 95.
This is the return per Nifty if the Nifty trades between 5000 and 7000 until the end of December.
This Rs 95 is the return for 8 months. That works out to be approximately Rs 12 per month.
Now also the Nifty is around the same level. Slightly lower at about 5900.
But one big difference is that the VIX is around 28, almost double of May VIX level.
Now the 5000 Put option is at Rs 73 and 7000 Call option is Rs 28. The total premium is Rs 73 + Rs 28 = Rs 101.
Earlier it was Rs 95 for 8 months.
Now it is Rs 101 for only three and half months.
Per month basis, earlier it was only Rs 12, but now it is Rs 30.
So premiums have shot up by almost 250%.
This is the effect of VIX.
If you feel that the markets will trade between 5000 and 7000, had you set up the trade when the VIX was 15, you would have got only Rs 12 per Nifty, now you will get 250% more at Rs 30.
So if you decide a range then wait for the VIX to shoot up, then set up the trade.
Those who take long term view about the market, should use this kind of opportunity to set up the trade.
For example, now December 2014 expiry, 3500 Put option is trading at Rs 80 and 8500 Call option is trading at Rs 100. A total premium of Rs 9000 per lot for a span margin payment of about Rs 20000. This gives a return of about 45% for about 15 months.
This gives annualised return of about 30% plus, which is a very decent return considering the range of 3500 and 8500.
Even in the October expiry, 4400 Put option is trading at Rs 10 which gives a return of about 5%. The level of 4400 ia about 30% lower from here. When the VIX is low, premiums at 30% below the market level will not even be Rs 1 or 2.
So do not go long or short when the VIX is high. Sell Put and Call options at a comfortably long distance to make good money when the VIX falls.
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