Sentiment Tools: Taking the Temperature of the Market With the VIX, Part 1

Random movements in the stock market are very tough to explain but if we can understand the role of sentiment, these moves make sense.  Remember, stocks move along the spectrum of fear and greed, a chart being an excellent portrayal of these emotions.  We can point to several sentiment-related indicators to get a pulse of market players, this is especially useful in the short run.  In part 1 of a series, we’ll take a look at some of these and how they impact decisions and market movement.

A chart can tell us everything we need to know about emotions.  Buying and selling are the actions of emotions fear and greed.  But sentiment tends to build and compound, much like an adrenaline rush we can overdose on one or the other.  Certain points in time we can run too far on either end of the spectrum, it is at these moments when the bus becomes too full and a turn is likely to happen.

The VIX, or volatility index (fear index) is a superb tool which tells us where short term option players are placing their bets.  The VIX rises when fear is present, drops when the fear subsides.  What worries markets and causes the VIX to rise?  Basically it is uncertainty over future events and high complacency.  If traders/investors become too greedy it shows up in a very low VIX reading, much like we have currently (VIX is at 13%, the lowest of the year and the lowest since December).

What does this mean?  Simply put the market is not showing worry about stocks going down, but a contrarian thinker might say there are no buyers left at this point and seller are only left to act.  When everyone is in the pool and has bought there is little left to boost stock prices (or so the theory goes).

When the VIX is elevated that normally tells us fear is rising and buyers are absent, and that has often presented opportunities to buy when extreme levels are reached.  But how do we know?  I will bracket the daily VIX chart with Bollinger bands, two standard deviations from the mean.  The bands capture 95% of the price action in VIX but it is the moves toward the upper band and through it that tell us the best times where a reversal is about to happen.  Take a look at the chart below.

vix bl