The Death of Volatility Futures: Why VIX Trading is Dead in India.

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The Indian public was first provided an opportunity to trade on a stock market Index directly thanks to the introduction of Derivative trading on the NSE in June-2000. One year later, in June-2001, Index options were introduced and in the months ahead, NSE introduced trading in Stock Options and later Stock Futures as well.

Futures moves in-line with the underlying stock (or index). Options on the other hand are a different animal with multiple factors driving the price of an option at a single point of time. A key factor that drives pricing of options is the volatility one anticipates in the coming days. If you anticipate a wide variation, for example due to Results, the price of a stock option will be higher than it is during other periods. If on the other hand, one anticipates not much of a movement, option prices could be relatively cheap.

One thing that seems to be true 95% of the time is that Implied Volatility, the estimated future Volatility, is always a keg higher than actual realized volatility. It’s better to be safe than sorry: that is the mantra of the option seller, for he has more to lose than the option buyer who would lose only the premium paid.

Measuring Volatility

Measuring actual historical volatility is easy. A simple way to calculate historical volatility is to calculate the Standard Deviation. You can do this in Excel if you have enough data points to calculate. For example, taking the price of the Nifty over the last 250 days, and using the formula STDEV in Excel will give you the standard deviation of the Nifty in the period. That is a proxy for the historical volatility in the index.

But how do you track Implied volatility demanded by the market?

When you buy an option, you pay a price that includes the “time value” of the option. That price is driven by the number of days left to expiry, the distance of the option’s strike price from the current market price of the stock or index, and the “implied volatility”, or how volatile you expect the market to be.

Calculating this implied volatility has multiple methods:

You can use any of the above to find the “IV” or Implied volatility, given a market price of an option.

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But an option is just one option. Stocks, or indexes, have multiple options. You can have the Nifty at 9200 but there are call options at 9200, 9300 and so on, and then put options too. How can you get the “implied volatility of the Nifty”?

Enter the VIX.

Menachem Brenner and Dan Galai in 1986 formulated through an academic paper a Volatility Index they called Sigma Index.  In 1993, CBOE started real-time reporting of the CBOE Market Volatility Index or VIX.

VIX provides a context with regard to the changes in implied volatility and comparison with actual realized volatility. While Index Options were launched in June 2001, thanks to an agreement between CBOE and NSE, India VIX was launched in early 2008.

How is India VIX Calculated?

India VIX* is a volatility index based on NIFTY Index Option prices. From the best bid-ask prices of NIFTY Options contracts, a volatility figure (%) is calculated which indicates the expected market volatility over the next 30 calendar days. India VIX uses the computation methodology of CBOE, with suitable amendments to adapt to the NIFTY options order book.   (Source: NSE)

A Premium read: Optionalysis: An introduction to the VIX.

While it’s nice to get a historical context to volatility, without the ability to trade India VIX, it’s a doll in a museum.

In US, CBOE launched futures trading on VIX in 2003 and subsequently trading though options was introduced in 2006. Following its footsteps, NSE launched India VIX futures in February 2014.

With the new product being widely anticipated, trading started off with a bang with 515 Crore worth of futures being traded in February and 1677 Crores worth of Futures being traded in the first full month of India VIX futures trading.

But from there, it’s been a downswing all the way to the extent that in the financial year 2016-2017, we saw just a single transaction being recorded!

So, what went Wrong?

Derivative trading in India has taken off on a scale that has been unprecedented. In 2015, Options traded on CNX Nifty at the National Stock Exchange was the top traded Index worldwide. In terms of total volume traded on any exchange, NSE came a close second to CME Group.

On CBOE, Futures trading in VIX has taken off really well with volumes picking up even as the Underlying VIX itself is seeing lows never seen in a long time. (US VIX is at or near all-time lows)

Given that traders would love to hedge their exposure to volatility, why has India VIX performed so badly that there is barely a trade for months on end?

Bad Product Design, Lack of Liquidity

One key reason was that VIX started off with a higher contract size compared to Equity / Index derivatives. A high contract size also means a higher level of margin which is a factor that can dissuade many a speculator.

As on date, each contract of India VIX futures has a Notional Value of 9.6 Lakhs. Margin is 14% which comes to 1.35 Lakhs per contract. The Nifty 50 on the other hand has a margin requirement of just 55,000.

India VIX was the first instrument where NSE launched weekly settlement series. Meaning, the contract expires every week. (Nifty futures and options expire once a month)

This incongruence has failed for India VIX.  One key goal for a buyer / seller of volatility is  to hedge his exposure. But with just 3 weeks of expirations available at any point of time, this is too close a time to hedge much.  The closer the expiry date, more is the impact of Time (Theta) than impact of Volatility (Vega). The decay in time value, or Theta decay, will impact prices of options much more than an impact of changing volatility (Vega).

CBOE on the other hand has the ability to introduce multiple contracts with longer  time frames, and therefore gets more interest.

The second problem is of complexity and lack of institutional presence. You want to hedge volatility, so you will need to hedge only a portion of your exposure. This calculation isn’t easy or intended to be, and is useful mostly for sellers of options. In India, institutions can’t sell options (for the most part). From insurers to mutual funds to pension funds, selling options is either disallowed or not practiced. Hedge funds are tiny. Foreign investors have shown little or no interest. Retail investors are too small. Volumes on volatility hedges make sense only to large players, and the large players don’t or can’t participate.

Our View

India VIX is currently trading near its all-time low and this may actually be a ideal time to lock-in volatility if the anticipation is that of a mean reversion being seen over time. But with just 3 contracts on the VIX and no guarantee of ability to roll over the contract, the whole concept becomes a venture which doesn’t add up either to the buyer or the seller.