Spot Market Reversals With the VIX

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October 13, 2008

Though most stock traders struggle with predicting the market’s next trend, it is possible to do so effectively, and consistently. All they need is the right tool. The CBOE Volatility Index - or VIX - is such a tool, indicative of the market’s underlying opinion about stocks at any given time. There’s a curve ball though… when the VIX indicates most investors are bullish, it’s best to start trading bearishly. When the VIX is most bearish, it’s time to start adding bullish trades.

The concept is called contrarianism. That’s simply a word to describe the trading approach of taking a minority stance. Yet, the strategy has a strong niche following within the investing world, primarily because it works well when applied correctly.

Sentiment Analysis

Sentiment analysis is the practice of studying investor opinion for the purpose of finding the market’s tops and bottoms. However, most sentiment indicators are interpreted in opposition of the majority opinion…a contrarian viewpoint. In other words, when most investors are bullish, contrarians are bearish. When most investors are bearish, contrarians are bullish.

To be clear, the market’s bullish or bearish opinions need to be quite decisive - or at an extreme - to have any real meaning to a sentiment analyst or a contrarian. Why? That’s generally when trends start or stop. Moderate opinions are generally not associated with a reversal or exhaustion of a trend.

VIX as a Contrarian Tool

The CBOE Volatility Index (VIX) is an effective sentiment tool that uses option prices (put and calls) as part of the calculation for its reading, or trading level. A high score indicates that put options are in higher relative demand, indicative of fear or worry - investors buy puts to hedge portfolios when it’s assumed the market is going to move lower. A low VIX reading indicates that call options are in higher relative demand, and is an indication of optimism - traders buy calls to capitalize on a rising market.

Most of the time, the VIX’s score is nominal, or at meaningless levels. On occasion though - when opinions are very strong - the VIX moves outside of its normal range. However, these moves are often short-lived, as those levels of fear or greed can not be sustained. Moreover, those levels of fear or greed tend to surface at the end of trends, or the beginning of new ones.

When the VIX chart makes a pointed spike, fear is said to have peaked. A selloff frequently turns into a rebound at that point in time. When the VIX chart makes a pointed low reading, confidence is said to have hit its maximum level. Strong rallies tend to become selloffs at these times.

Whenever the VIX makes one of these key reversals, traders have a high-odds entry point into short or long trades, or at least an optimal exit opportunity.

Why Contrarianism Works

Logic leads most investors to think that a broad bullish opinion would actually force stocks higher rather than lower. That’s generally true, particularly in the early stages of a rally. But, sentiment tools like the VIX are best used when opinions are nearly unanimous, or at stretched readings.

By the point in time the VIX reaches unusually low levels and makes a sharp, pointed bottom (in a bullish case), all the potential buyers are already in their bullish trades and there are very few willing buyers left. If there are no new buyers pumping money in to keep pushing stocks higher, the current owners become impatient and start taking profits. This sends stocks lower.

Conversely, the VIX will only move to an extremely high reading after most sellers are out of their long trades, and perhaps already in short trades. The market eventually runs out of sellers or bearish parties, which causes the VIX to make peak. The buyers usually start to pour in again then, uncontested by any sellers. As a result, stocks start to rise.

The attached charts illustrate how effective the VIX can be at spotting tops and bottoms.

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