NSE launches VIX futures to enable trading in volatility

The National Stock Exchange on Wednesday launched future contracts on India VIX enabling traders to hedge market risk arising out of volatility. The launch of VIX futures comes at a crucial time as markets are expected to be jittery prior to elections which are due by May.

Bank of America Merrill Lynch analysts Jyotivardhan Jaipuria and Anand Kumar say VIX rises ahead of election results and falls post result announcement.

"India VIX increased from 36 per cent on April 1, 2009 to 55 per cent a few days before results. However, it fell sharply to 43 per cent once results were announced. We would expect VIX to rise as we near May this year too," the two analysts said in a report published earlier this month.

The volatility index is often referred to as the fear index or the fear gauge because as it rises, market participants need to become more proactive and careful about their portfolios.

Here are 10 things to know about the newly launched NVIX future contract:

1) India VIX measures investors' perception of market volatility over a 30-day period. In 2013, India VIX values ranged between 13 and 32.

2) NVIX contracts can help traders in hedging equity portfolios, diversify the portfolio by adding India VIX futures. Option traders can hedge vega risk (measures the risk of gain or loss resulting from changes in volatility) in their option portfolios. Investors will be able to take directional views on volatility. Calendar spread (simultaneous purchase of futures or options expiring at particular date and the sale of the same instrument expiring another date) trading can be explored across weekly contracts.

3) India VIX is perceived to be one of the best tools to predict near-term market volatility. It starts to increase at the time of stress in the markets and falls as investors become calm. High volatility is an indication of sharp up or down movement in markets, while a fall in volatility signifies sideways movement.

(Relationship between India VIX and Nifty, source NSE)

4) According to Bank of America Merrill Lynch, the correlation between Nifty and VIX over last 5 years is negative 0.84 (meaning when Nifty rises, VIX falls and vice versa), making it a strong indicator for prediction of stress in markets.

5) VIX trends: BoAML says once the VIX has peaked, markets usually give a positive return over one week and one month. Of the four instances when India VIX has crossed 30 per cent mark, Nifty has always given a positive return with average return of 6.5 per cent in a month.

6) To measure the minutest change in volatility, values will be computed up to 4 decimal places (like in the case of currency trading) as market participants may like to analyse impact on prices due to small changes in volatility.

7) India VIX will be computed using the order book of the underlying Nifty options (near and next month) and will be denoted as an annualized percentage.

8) There will be three weekly futures contract for trading. The contracts will expire on every Tuesday. The tick size is 0.25.

9) Not meant for retail investors: The contract value would be minimum Rs 10 lakh, so is unlikely to be evoke interest from retail investors. Price will be quoted in multiples of 100. For example, to buy one contract of India VIX futures at 18.1475, quoted price will be Rs 1814.75. The contract value will be (Number of contracts* lot size * quoted price).

10) Settlement mechanism: Like other equity derivatives contract, India VIX futures shall be marked-to-market (MTM) on a daily basis. The MTM shall be netted along with other equity derivatives contract at the clearing member level. The contracts shall be cash settled.