Use this options sentiment indicator to gauge market extremes

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Following a trend has been my trading motto but every few months, there comes a time when you feel that the ongoing trend may have been overdone and there could be a reversal, if not respite, ahead.

I do not believe in being courageous and trying to catch a falling knife. But, I do believe that stocks and indices do get into a zone that requires one to slow down and shift direction to make room for possible reverse price action.

Spotting these price points is not so easy but there is a sentimental indicator created from options premium data that gives decent indications of the ever-changing market mood.

Before getting there, let us understand one property of option premiums. Option premiums are not the same at times. Let me explain with an example.

Scenario 1:

Stock on Day1: Rs 90
Stock on Day15: Rs 100

Monthly Expiry 100 Call on Day15: Rs 2

Scenario 2:

Stock on Day1: Rs 110
Stock on Day15: Rs 100

Monthly Expiry 100 Call on Day15: Rs 3

As we can see in both scenarios, the same option has the same strike price and same stock price on Day 15 but the premiums are different. The key characteristic to be observed here is that “falling stock has relatively higher premiums, rising stocks have relatively lower premiums.”

The reason is simple. An option seller will sell more expensive in falling times because price destruction is faster than price rise. In other words, the higher the risk of falling, the higher the premium.

But Rs 2 and Rs 3 are the premiums of a particular option, how do we find out the risk for all options without comparing the prices from 15 days before?

India VIX, also known as the risk index, helps us get a number that identifies the Nifty Option indicated risk. India VIX is available on NSE website for free.

What is India VIX and how it is calculated is a topic for another day but a rising India VIX tells us that the risk of a fall in the market are increasing.

India VIX has a couple of properties that help us identify market extremes.

1 India VIX has a mean reverting: It does trend in the shorter term but more or less India VIX moves in a range. After reaching a high if there is no shock in the market, it possibly peaks and turns around

2 India VIX has a negative correlation with the market: The India VIX falls while the market rises and the other way around. (The relationship holds on a generalised basis).

Though not often but there are times when India VIX falls in a falling market or rises with a rising trend.

These are the times when we can sense that an extreme fall could have been made and India VIX may continue to decline. The market may halt the fall and recover a little.

Similarly in case of a rise, the risk levels may keep increasing and the market may halt or start to pull back.

This is a unique relationship that is globally followed, thanks to the options premium created sentiment indicator called India VIX.

It certainly doesn’t mean we should start living dangerously but India VIX can help us lower the aggression and start taking safe, lower risky reverse bets.

This sentiment indicator has helped me avoid being overloaded with “buy” or “sell” positions on turning points, hope it helps you as well.

Disclaimer: The views and investment tips expressed by experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.