Reading the VIX: What the 'Fear Index' Is Saying Now

"When the VIX is high, it's time to buy. When the VIX is low, it's time to go."

That Wall Street truism led to my April 25 report that suggested the extreme low in the VIX index ($VIX) might be signaling a top in stocks. While the VIX didn't "ring a bell at the top," the market did roll over within a week and begin a long decline to its July lows.

Those who sold speculative positions in late April when the VIX was low and bought back in late June when the VIX spiked up (and the market hit bottom) were rewarded for paying attention to the VIX.

Why is the VIX a staple of Wall Street traders? The VIX is the Chicago Board Options Exchange's (CBOE) Volatility Index, and it measures the volatility of S&P 500 index options. When the demand for puts -- options that rise in value if the market falls -- rises sharply, that's a reflection of fear or uncertainty. Hence, the VIX's nickname as "the fear index."

Is the News Expected or a Surprise?

One way to interpret the VIX is to view the market as a discounting mechanism. When all the good news is reflected in the market price, then the market is set up to respond with surprise and uncertainty to unexpected bad news.

When the market has absorbed all the bad news, in effect discounting it by dropping to lows, then it's set up to be surprised by unexpectedly good news.

In late April, the bad news about the Eurozone's sovereign debt issues was discounted. The market reflected a general confidence that the situation was under control, and the VIX remained subdued. When it became clear that Greek debts were a potentially major problem to Eurozone banks and financial stability, this "unexpected bad news" sent the VIX skyward and made the markets tumble.

Let's look at a current chart of the VIX and see what insights it offers. The chart may look cluttered, but we'll examine each piece separately.

What pops out of this chart first is the big spike up in May as the U.S. stock market grasped the deeply negative consequences of the European sovereign debt crisis. When news spooks the market, the VIX tends to "gap up," that is, open much higher than its level on the previous day. I've drawn rectangles around the big gap-ups.

Note the big gaps that opened up as the Eurozone banking crisis exploded in late April and May. But since topping out in mid-May, ensuing gap-ups have reversed in two or three days. Rather than announce the beginning of a new trend, these are classic spikes of sudden jitters that quickly dissipate.

Becoming Comfortably Numb?

Despite a steady drumbeat of negative economic news, the VIX has been in a downtrend since mid-May. Sharp drops in the stock market have not sent the VIX into the same nosebleed territory it reached in mid-May. It's as if the market drops that have been occurring with great frequency in the past few months no longer elicit much fear.

This suggests that either the market is becoming numb to "negative surprises" or that bad news is now "old news." Whatever the explanation, the VIX has been sliding even as the economic news continues to be unsettling.

Since June, the VIX's spikes have followed a specific pattern: Some bit of news sends the market into a tizzy of doubt and fear, and the VIX gaps up. But two or three days later, the index reverses course and drops back into its gradual downtrend.

Bollinger Bands offer another charting tool to assess market volatility and extremes of sentiment. In late June, the VIX leaped up to the upper Bollinger Band, signifying an extreme of volatility. That spike tracked the market bottom: "When the VIX is high, it's time to buy."

The VIX gapped up strongly on Aug. 11, and then broke through the upper Bollinger Band. If this is a repeat of the June and July pattern, it would signify a buying opportunity. On the other hand, if the VIX doesn't quickly reverse course and drop back down to its lows within a few days, then it might be the harbinger of a new trend: up in the VIX and down in the stock market.

Ready to Enter New Territory?

For clues, we can look at the recent highs in the VIX. Did this latest spike of fear exceed the highs of July? No, it reached the same level, around 27. That suggests the current uncertainty is roughly equivalent to the levels experienced in the last month.

But some evidence also hints that the VIX might be signaling a longer-term trend change. The spike up this week has broken the downtrend since May, and the trend indicators of MACD (moving average convergence-divergence) and stochastics are turned upward.

Put all this together, and it suggests that if the VIX falls back to the low 20s early next week, the market has absorbed and discounted the latest "bad news" as not very surprising or very important. But if the VIX remains stubbornly high, or gaps even higher, that would suggest the market perceives greater risk ahead. That would not be a buy signal, but rather a warning light of caution.

The VIX isn't a perfect indicator that rings a bell at the top or bottom, but it does reflect extremes of sentiment that tend to mark tops and bottoms, and general trends of market sentiment. Both are useful bits of information to investors and traders alike.