There is a clear dichotomy between what an investor experiences and what the investor visualises, when you talk about “riding the bull”. In sport, riding the bull entails the rider remaining mounted on the bull for at least eight seconds, even as the bull turns and kicks, attempting to throw the rider off its back. In stock market, when you say, “riding the bull’, it refers to participating in a large upmove in the market, resulting in extraordinary gains to your portfolio. But just like in sport, the glory or gain, is often preceded by a period of very high turbulence, with fatal risk to one’s torso or portfolio. Unmistakably, the charm lies in the euphoric feeling of having outlived that period of uncertainty. It is this volatility that ensures that only few remain to taste the rich dividends that come after. Let us talk about volatility then. Literally, volatility refers to fluctuations, without setting a clear trend. Be that as it may, since only one direction matters to the investor, which is “up”, any trend that is not pointing upwards is seen as volatility. And that covers not only downsides, but also sideways period. Why, even a period of degrowth may be construed as volatility.
Trend is often seen as investor’s best friend. And Trend’s BFF is volatility. So, if you want to get to “Trend”, you will have to understand “volatility”. Volatility is often a very misunderstood theme. It is seen as the villain in your fairy tale of never-ending profitable runs, but scarcely remembered is the fact that volatility gives fresh entry level for further accumulation, a consolidation point so that stock prices do not collapse, while also stretching the time, reducing the risk of re-investment. Let us have a look at the various aspects that summed up as volatility in the month of February. Interest rate hikes have been a recurrent theme for markets since the last quarter of 2021. But come March, we will see all those expectations crystalising into a reality. Plus, several other seemingly unrelated events have conspired together bringing all the heat onto February. These events can be broadly classified into two: Liquidity and Uncertainty.
Fear of liquidity getting dried up
- Upcoming implementation of 50:50 cash-stock margin
- LIC IPO expected to attract high retail subscription
- Fiscal Year end prompting traders go slow on large bets
- Fed meet in March with rising chances of a 100bps rate hike
- State Elections
- Russia-Ukraine impasse
- Rising oil, and the prospects of US-Iran nuclear deal
All this heat ended up dragging Nifty 50 lower, with the 60-day moving average of the benchmark index seen nearly 5% below the January peak. But this does not adequately reflect the state of mind of the traders or their future expectations. For this, a volatility index serves as a better benchmark rather than a price index like Nifty 50. India VIX is such a volatility index, which represents the expected volatility over the next 30 calendar days.
The key components that go into the making of VIX are:
- Time to expiry
- Interest Rate
- Nifty Future price
- Bid-Ask quotes of Nifty OTM options
Except during the 2020 debacle, VIX has largely stayed below 18, save a few, but brief spikes. But, since the third week of January, VIX remained high and inside 18-22 except for 10th of February, which saw VIX falling to 17.71 having seen three days of consecutive positive close in Nifty. In other words, for the last one and half months, traders persistently harboured the fear of volatility, or lack of clarity in direction. This reflected in the derivative space, by way of expensive straddles. Nifty straddles, which were fetching 100-250 on an average in January, began to be seen trading in the 250-400 region since the last week of January. Stocks reflected on volatility differently meanwhile. Around 75% of the NSE 500 stocks continued to have a trading range of -2% to 2% throughout January and February, but while around 70% of these stocks gave a return of 0 to 2% in January, only around 30% gave similar return in February. If VIX were to move further above 22 in March, which we feel is possible, then straddles are likely to get more expensive, while more stocks are likely to break out of the -2 to 2 % daily trading band.