December 4, 2013

Drop in VIX and option prices

Last 2-3 days witnessed a substantial increase in VIX - this has a direct implication on option pricing and makes option expensive. Higher VIX implies greater risk or fear so option writers charge higher premiums.

VIX is reflected in option pricing via something called implied volatility. It is something every trader should know and not trade options unless one is thorough about ABCs of option pricing.

Today there was a drop in VIX of 4% even though markets closed in the red. Now one would expect that anyone who bought puts yesterday at close would have profited very nicely today.

Something else happened. While nifty futures fell from 6250 yesterday to 6213 today (last trade), the 6200 put moved from 135 to 142 only. A fall of 37 points in nifty generated a profit of only 7 points in the put option.

All this was because of a 4-5% drop in VIX. And this is something which happens quite often.

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