What is relation between the index ( VIX ) and the options pricing.
In Black Scholes model of options pricing, the call and put options pricing is dependent on following 5 factors:
1) Price of the underlying
2) Strike price
3) Risk free rate of interest
4) Time to expiry
Out of these five factors, first four are factual in nature.
We all know the price of the underlying, strike price, risk free rate of interest, time to expiry at the time of writing an option.
What you don’t know is the Volatility in the near future and thus it is somewhat subjective in nature and derives from the anxiety or fear of the option writer.
This is called implied volatility and it reflects the sentiment of a option writer.
If the option writer thinks that in the near future the is going to be high, he would demand
higher premium for writing an option and thus the prices of the options will be higher.
On the other hand if he thinks the is going to be lower, he will demand lesser premium for the
options and thus lower option prices.
Now if we consider all the option writers present in the market. There would be millions of such people and if we try to calculate
the average from the options they have written, we can get a value which can describe the overall sentiments of the market about .
This is what Index really tells us. It uses the prices of the options to guess the future , ofcourse, after doing several other operations
as well but in a nutshell, it is the reverse process of option pricing taken all the options being traded into account and thus calculating the sentiment of the entire market.
We can read the exact method of calculating India VIX here.
Now what does a particular value of the India VIX indicates?
Value of India VIX at the time of writing this article (24/08/17) is 12.5725 which means people are thinking that over the next 30 days markets can move up or down by 3.6293%
and demanding premium as per this value. Low value of VIX indicates stability in the market while higher value indicated stress, fear and anxiety.
Since, the investors are more fearful of the downside, VIX is negatively correlated to the stock market index like Nifty or Sensex which means
as the market index drops the VIX value increases & vice-versa.
Try to post another article, discussing the correlation between India VIX and Nifty and how VIX can be used as a hedging tool once India VIX and options are introduced.
OT: It is observed that, some of the words or numbers in the message field get a hyper link activated, which is spoiling the beauty and content of the message.
I have mentioned this to the admin long back, but it become a futile effort. There are are bugs too in the message area of the post.
I request every authors, whoever face such issue must notify to the admin. some day they will correct it.
To avoid such disturbance, what i do is, I am putting an apostrophe mark after the subjective word like, NIFTY' or VIX'. How is that? :D