Using volatility as a directional guide, explains Shubham Agarwal

F&O Cues

Volatility is usually talked about as more of a characteristic of the market. The meaning of volatility in simple terms is also just a speed of movement. The better-known word for it is momentum.

One would wonder just by tracking the momentum how would we be able to get any gauge of the direction. The answer lies in the relationship between speed of movement or Volatility and the Equity as an asset class. The relationship is established. Historically it has been seen that Volatility and Equity / equity Index move in Opposite directions.

The reason is quite simple. The law of nature says that making something or a constructive move is always time consuming. On the other hand, any destructive move is very fast. This is because breaking something is really easy.

Coming down to equity as an example, constructive move in equity is going up and will have a very slow momentum or volatility. Similarly, fall in equity usually comes very fast and with a great momentum. This proves the relationship to be negative.

Following chart shows the equity index Nifty and India VIX (Volatility Index for Nifty Index).

The green notations give enough evidence of the negative relationship. We can see the temporary tops in India VIX being falling along side temporary bottoms in the Nifty.

Now let us look at another characteristic of Volatility. As we all know, equity or equity index for that matter can go from 10 to 100 to 1000 and even to 10000. However, Volatility or Momentum does not go distance it is more like a cardiogram, it increases and decreases.

It similar to a Car where Speed is between 0-100 but the distance can be 100,1,000 or even 100,000. That points to another characteristic. This is popularly known as mean reverting characteristic. The move is in a range in short.

Now we can combine these 2 characteristics and make Volatility help us with being a directional guide.

Mean reverting characteristics, mean Volatility will come back to the mean or the average value every time it tries to move away from the average. In other words, too much higher or too much lower values may not sustain for long time.

The best way to detect this is by waiting for the high to be established. This means that if previous highest point is reached, we wait. We see at least a day to record value lower than the highest value recorded recently. After one day of fall, we establish a probability of Volatility to go down to its average.

Considering the negative relationship, now the tradable index Nifty can be expected to start rising alongside fall in Volatility.

This is how we get Volatility to help in creating directional move expectation. There are traders who take trades based on this only. I do not insist on that but at least when Nifty is falling and India VIX is rising, a day’s fall in India VIX can help build an expectation of rise and lead us to look at bargain hunting.

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