After witnessing high volatility for about five months since the beginning of calendar 2008, stability is slowly returning to the Indian equity markets. And that is good news for traders and investors as stable times and safer market conditions see cheaper derivative contracts. Derivatives are financial instruments (contracts) whose value changes in according to the change in value of the underlying asset (shares or index in this case).
The volatility index of the National Stock Exchange that measures the expected near-term volatility in stocks, has almost halved to 28 points (five-day average) from a high of 54.41 points it touched in late January – when the benchmark Sensex of the Bombay Stock Exchange lost a good 10 per cent in just 15 sessions. This is a good sign for the equity markets. Low volatility reduces the cost-of-carry or the cost of holding a derivative contract. Cheaper contracts woo more players into the market, thus providing it the much-needed buying support.
“Nifty volatility index has come down sharply, which means stability is returning to the markets,” said Alex Mathew, head of research of Geojit Financial Services.
Historically, the markets have seen sharp rallies following low volatility. For instance, in June 2005, when market volatility touched a low of 11.8 per cent, the Nifty gained 23 per cent from 2100 points to close September 2005 at 2600 points, according to the head of a Mumbai-based brokerage firm.
Volatility or the rate and magnitude of change in prices (often called risk) is the degree by which the price of an underlying asset or value of an index fluctuates. Usually, during periods of high volatility, markets tend lower as investors' perception of risk is high and many players exit. High volatility or expectation of huge price fluctuations push up the premiums of both call (the right to buy at a certain price) and put (the right to sell at a certain price) options. Costlier contracts turn off hedgers and traders from the markets.