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In a very real way the VIX reflects the fear of the general population of investors. This can be useful as a way to understand the strength of a given trend and as a way to forecast reversals in the market.
The VIX will show the relative risk or fear in the market compared to recent history. Traders will try to identify those points in the VIX when investor sentiment or fear has reached extremes. In the video below, I will show you several good examples of what to look for to find periods of excessive fear and bearishness, as well as too much bullishness. These periods often lead to reversals in the market, which is a good time to reduce market exposure and begin looking for new opportunities.
One of the things we look for when evaluating whether the VIX or investor sentiment is at extremes is whether or not the index is at the top or bottom of its channel. When the index is at resistance (the top of the channel,) we know that fear is at an extreme and we should be controlling any market exposure to the downside of the market very conservatively. It does not mean that we should automatically become bullish but, it does mean that we will act as prudently as possible to control the risk in any short positions or long puts.
Conversely, the market and traders in general can become over confident. Quite often a bounce off the lower side of the channel can indicate a significant shift in investor sentiment from low risk and growth to high risk and volatility. The channels on the VIX will shift over time but typically stay within a given range, such as the one shown on the chart, for several quarters to a few years.
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