The Nifty has lost nearly 29% since the peak of mid-February. This is despite a 14% jump in the last 4 days of this week. One factor that has highlighted the huge fall in the market has been sharply higher VIX levels. This may have to be watched closely in the coming days.
What is VIX all about?
The VIX is the volatility that is implied in the option pricing. Instead of just a single strike, a series of strikes around the spot price is taken and the IVs are averaged to arrive at the VIX. The VIX is also called the fear index as it shows the amount of fear implicit in option pricing. A higher level of VIX is an indication of a high degree of fear and uncertainty in the markets and is normally bearish.
VIX versus the Nifty
One of the most important relationships to understand is the one between the VIX and the Nifty levels. Historically, the Nifty and the VIX charts have moved exactly opposite to each other. VIX level of 20 and below are considered to be conducive to an up move in the indices. Throughout most of the last few years, the VIX has been in the region of 12-16. At these levels, the markets are seen as safe and any correction is soon met with interested buyers. In other words, you can say that downsides are limited. When the VIX tends to peak above 50, that is when the steep market falls are seen as also the sharpest corrections.
How is VIX behaving currently?
VIX had first touched a peak of 85 during the peak of the Lehman crisis in 2008. After that, there have been bouts of spikes in VIX but it never got back to those levels. During April and May 2019, VIX had spiked to above 40 due to the election uncertainty but these levels tapered post the outcome. However, since the middle of Feb-20, the VIX has been consistently above the 50 levels and even touched a peak of 86.60 during this period. However, even after the recent bounce, the VIX continues to be elevated around the 70 levels. During the same period, the Nifty has fallen sharply by over 33%.
How to interpret the VIX
How do you interpret the VIX at above 70 levels with the Nifty showing signs of a bounce and the government trying to boost the economy? Clearly, any reliable rally in the Nifty can only happen after the VIX tapers to lower levels. As we have seen in the last few weeks, as long as VIX is at such elevated levels, market rallies are likely to be led by short-covering and will face pressure at higher levels. That is why you find that when the VIX remains high, the indices test the lows multiple times. Markets tend to bottom out only after the VIX tapers to below 20 and the last bull is squeezed out of the market. Sharp falls rarely exhibit a V-shaped recovery. It is a long grinding return to the previous high!