Despite all of the gloom and doom you hear about lately, the VIX is actually telling us that things are a bit too complacent. And since many traders seem stymied by the recent VIX action, I want to show you a more effective way to use the VIX, combined with other indicators, to tell us which direction the market is headed. 

Traders have been talking about the fact that the “open interest put-to-call ratio” was telling a very different story than the “average implied volatility gap between puts and calls on the VIX.” Each one is used to predict what the VIX is going to do, which, in turn, is used to predict what the market is going to do. In theory, if the VIX is going to move higher, that means people are going to be more fearful, and that means the market is headed lower (people would be more fearful as they saw the market decline). Conversely, if the VIX is headed lower, the market should be headed up.

The open interest put-to-call ratio has been suggesting a decline in the VIX (i.e., stock market calm to come, which is bullish for equity markets), while the average implied volatility gap between puts and calls on the VIX has been indicating a sharp spike in the VIX (i.e., fear is coming, which is bearish for equity markets).

A Quick VIX Review

The CBOE Volatility Index, also known as the “fear gauge” and commonly called the VIX, is best used to find market bottoms. It’s more effective at telling traders when fear is so high that they need to sober up and become one of the few buyers of cheap stocks that nobody wants.

Basically, the VIX reflects how overpriced or underpriced options (insurance) are. When traders become more fearful, they buy options. When they are scared out of their minds, they are willing to overpay for options — just like a person who thinks they have a high risk of health problems or death would be willing to pay high insurance rates — and the VIX goes up. Heck, if you were 99% convinced that you’d face the grim reaper in the next few months, you would probably pay 10 times the average monthly rate for life insurance, which is why the VIX, now around 21, was approaching 100 during the 2008 crash. 

The VIX is better used to call market bottoms than tops because complacency and fear are more gradual, while extreme fear tends to be short-lived, creating an opportunity that you can trade. When VIX spikes too high and reverses, that’s a market buy signal.

But sometimes we are able to use the VIX as a signal that investors are way too complacent. There is a VIX “buy signal” (stock market “sell signal”) that I make an exception for, and even when I see this signal, I still use it as more of a red flag than something I immediately trade off of. 

Using Bollinger Bands With the VIX

What you can do is use Bollinger bands with a daily chart of the VIX. Bollinger bands are used to determine overbought or oversold levels, selling a stock or ETF when prices touch the upper band, and vise versa. Bollinger bands measure deviations (e.g., 1 standard deviation, 2 standard deviations, etc.).

I set the Bollinger bands parameters at “20, 2” (usually the default settings on a chart service) for the chart above. You can see four red arrows showing where “buy signals” occurred. The S&P 500 is at the top, and the chart of the VIX is the main bottom part of the chart. You can see when the lower band was violated, followed by a move higher, the S&P 500 was close to a sell-off. That’s just what happened last week. Typically, the market takes a week or two to begin to correct once this occurs.  

It’s no wonder we are seeing conflicting VIX prediction signals on some of the indicators. The market has seen one of the longest periods of indecision in recent history. The general market has been trading sideways after the six-to-seven-month rally off of the March, 2009 low. While we have had swift moves up and down, the rally off the March 2009 lows essentially stalled in October (when considering the long-term trend).

Markets became fearful in late October 2009 when the sovereign debt monster first showed its face in Dubai, and Greece came out and said their budget deficit wasn’t 3.7% of GDP, but was 12.7% of GDP (oops, just a minor accounting error). The VIX Bollinger band signaled over-complacency in mid-September.

The next time the VIX Bollinger band signaled over-complacency was in January 2010 (right before the sovereign debt fears surfaced again). Then once again in April, when investors realized the sovereign debt issue wasn’t just going to go away. We recently started hearing about the sovereign debt issue again, and we got the same signal. 

I don’t know if the market declines from here or breaks out. But my feeling is that, if we get a breakout, it will be short lived (a couple months max), followed by another sharp move down. If the market breaks down from here, however, taking out the 1,040 lows on the S&P 500, my feeling is it will be a sustained move lower.   

2 Other Indicators to Watch

It is important of take a synergistic approach to investing/trading, so let’s look at two other sentiment indicators.

First the ISEE call/put ratio. Long story short, when this index gets up over 150, it’s a red flag that we are getting too complacent and the market is due for at least a correction 

Below you can see the top chart is the S&P 500 and the bottom is the ISEE Index. I went back one year, six months at a time. You can see this has been a pretty darn good indicator at calling the nosebleed seats. It’s not a “timing” tool. As you can see, the index poked its head slightly above the 150 mark a few times in March, 2010, and really spiked in April before the huge sell-off. We also saw a sharp spike in August, at the last major high. We just saw another pop above 150, but not a huge one. I will be watching this indicator closely, but I already have seen enough lately to make me very cautious. 

Next, the Investors Intelligence Advisor Sentiment Index. Long story short, the chart below shows the difference between the bears and the bulls. For example, when 40% of advisers are bullish and 35% are bearish, the difference is a 5% reading. When the reading moves below a 15% difference, and then advances, it’s seen as a buy signal, meaning we are likely at or near a bottom. 

We actually just saw a buy signal. But I want to show you something. In the chart above, you can see the indicator plotted on the bottom half and the S&P 500 plotted above. In 2008, we see an example (left red circle) where the indicator showed extreme bearishness, gave a buy signal (which was actually a good signal), as the market moved from above 1,270 to about 1,440. But as you can see, that didn’t stop the long-term trend from continuing lower. 

As I said, we just got a buy signal from this indicator. And we also did just see a quick pop in the market … and maybe it will move higher form here. But remember that this does not mean the long-term down trend won’t continue. 

The point here is to be cautious. Don’t worry if you see mixed signals. We will always see mixed signals, especially in a market that has price action proving that most investors are unsure what to think (for nearly a year). In fact, if you aren’t seeing mixed signals on some level, that’s when you know you aren’t looking at enough indicators. (They will always conflict, but you want to act when a large majority of the indicators you follow are saying the same thing.)

The best thing to do, in my opinion, is to stay hedged or stay out. If you put on both bullish and bearish options positions, whichever way the market decides to go next, you will have winners and losers.

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