Signs of Life in the India VIX

Asad Dossani

The India VIX measures the implied volatility of one-month Nifty options. Options are a lot like insurance contracts. Buying a put option insures you from a market crash. How? If the market drops, the put option increases in value. So put options can help protect your portfolio.

The option implied volatility, or the VIX, tells us how cheap or expensive options are. If the VIX is high, it means options are expensive. If it's low, then options are cheap. If we link this to the insurance scenario, a high VIX means high demand for insurance.

In the last one week, the India VIX moved from just over 11% to over 15%. That is an astronomical 36% jump in just one week. In other words, the cost of insurance has spiked dramatically.

The implication is that investors have become a lot more fearful. The demand for insurance has gone up. The higher demand is correlated with the overall market. In the last week, the Nifty is down around 3.5%. When the market goes down, fear goes up. As does the demand for insurance.

This week's move in the India VIX mirrors a similar move in the US. The VIX on the S&P 500 is up around 60% this week, an even more astronomical move.

Though fear has gone up, it remains low overall. The India VIX is still slightly below its long-run average. In fact, prior to this week, the VIX had been trading incredibly low by historical standards. This has been a big puzzle, since investors have had plenty to be nervous about.

The rise in the India VIX is good news for option sellers. Those looking to earn additional income from selling options have an edge when the VIX is high. Our latest online learning course, Derivantage, teaches you everything you need to know about options. When you want to earn income from selling options, or earn big returns with little risk, options are the tool for you.

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Market Notes

What to Do During the Euphoria Stage of a Bull Market

In a previous market note, we issued a word of caution. A simple valuation metric, the PE ratio, told us the stock markets are extremely overheated and due for a correction. The PE ratio was trading at 25.50, a level that brought a 25%+ correction to the Nifty 50 Index in November 2010 and March 2015.

We have conducted some data analysis on the Nifty Index's performance at different PE ratios.

The chart below shows the average Nifty six-month returns when the PE ratio is near its highs (above 25). We also calculated the average returns when the PE ratio is relatively low (below 16) and between 16 and 25 (normal PE).

Here are the results...

Nifty Six-Month Average Return at Different PE Levels

Note that if the PE ratio is above 25 several times during the six-month window, we consider only the first one and ignore the following ones in that window. But if the ratio is still above 25 after six months of the initial signal, we recalculate the six-month return. We did similar calculations for PEs below 16 and between 16-25.

As you can see in the chart above, when the PE ratio is high (above 25), the average six-month return is -10%. But when the ratio is relatively low (below 16), the average returns are 18%.

So entering the market when PEs are high could lead to a massive underperformance.

We have done similar calculations for these different holding periods. And the results were similar - that is, high PE levels will lead to underperformance.

Currently, we are placed at the upper band of the PE ratio. And this is the reason we said in the last note that stock markets are currently in the euphoria stage. And that it's time to be cautious.

But like we said, we cannot rely only on one measure. The PE ratio and the markets can keep going up - as they did in 2000 and 2008. But we also cannot ignore the historical data.

So what should you do during the euphoria stage of a bull market?

  1. Keep Trailing
  2. Risk management is the most important thing during the euphoria stage (indeed during every stage). You should have a strict stoploss in place. And if you have profitable trades open, follow them with a trailing stop loss. This helps you cut your losses and let your profit run. Since it's entirely possible the market will keep going up, it is smart to use a trailing stoploss strategy during market euphoria.

  3. Position Sizing
  4. This is another part of risk management. It is always recommended to risk only a small portion of your overall portfolio in a single stock. That way, if the stock gaps down and falls 25% tomorrow on some overnight news, you've only lost a small portion of your total portfolio...much easier to stomach than if you had a huge position. At Swing Trader, our short-term stock recommendation service, we risk not more than 0.5% of the total capital on any one trade.

  5. Asset Allocation
  6. Don't put all your eggs in one basket. You need to diversify your portfolio. If you are currently 100% in equities, give it a second thought. Look for other investment avenues like gold. This can help protect your portfolio and keep the inflows intact if stocks do correct in the coming months.

  7. Book Profits
  8. Don't keep profits on the table. Although you have a trailing stop loss in place, it is always a good idea to take some profit home, especially during a euphoria stage. Booking 25-50% profits and trailing the rest of the position is a good strategy to keep pocketing profits.

Following the steps outlined above can help protect your portfolio should the markets start to correct - as the current PE ratio indicates might happen. It will also help you stay in the markets should the bullish momentum continue.

If we go by the history, caution is the need of the hour. At least until we see the PE ratio cool a bit from the current level.

From The Market Wizards...

'The elements of good trading are: 1. cutting losses, 2. cutting losses, And 3. cutting losses. If you can follow these three rules, you may have a chance.' - Ed Seykota

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5 Responses to "Signs of Life in the India VIX"
Ashit Thaker
20 Aug, 2017
As usual of e1of the team , A very informative article . would like to know how and what to read in the VIX page of NSE. How to know the historical or the average/ mean reading. Ur derivantage would be covering all of this , ??? Do you have a physical training of derivantage instead of online as in a real class there is better info and interaction . Anyway's what can one do after learning from the derivantage (how fast / often can one apply the learning and how can it be transferred in to profitable trade ) Regards Ashit ThakerLike 
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