How to Profit from the Stock Market by Applying Volatility Index (VIX)

The CBOE Volatility Index (VIX) is a sentiment indicator that passively reflects the stock market movements. Therefore, the VIX is not used to predict the direction of the market. Instead, it should be applied to identify sentiment extremes and help investors and traders to detect optimal trading opportunities. 

 

Dramatic and unexpected stock market deterioration usually causes the extravagant spikes in the VIX reading, as panic dominates and penetrates the investor’s mind. If the spikes go beyond a specific level (measured by the moving average of VIX), then this indicates that a gigantic bearish sentiment can spur a market recovery. 

Technically speaking, when the market drops, the VIX can better detect the reversals. However, if the market is in bounding range or upward trending, the VIX does not work well. Under this circumstance, it is best to combine the VIX with other technical indicators such as RSI, ISEE, TRIN, SMFI, etc.

On the other hand, a sustainable and robust stock market gain yields a gradual downward and comparatively depressed level for this index. Undue bullishness makes it challenging to foretell if the market is going to continue its trending path. Therefore, the VIX can better detect the bottom than the top. It would be wise to apply the VIX, accompanied by other technical indicators, to identify imminent market reversals.

Occasionally, an unforeseen debacle might arouse the swell in VIX reading as well. For example, many investors and traders around the world still remember the outrageous flash crash which occurred on 5/6/2010. This created a broad and inverse impression of the stock market. 

As a matter of fact, the market started its correction from 4/26/2010 amidst the sovereign debt concern. However, the “fat-finger” incident just amplified the market moving magnitude. Even if the market recouped most of its losses at the end of day, the S&P index dipped to an intraday low of 1,065 and managed to close at 1,128. The S&P 500 index dropped 106 points in total from 4/26/2010 to 5/7/2010. Within the next three days, the S&P 500 snapped up half of the loss. Then the market resumed the downtrend after that. 

On 5/25/2010, the market broke its intraday low on 5/6/2010 and reached the low of 1,040. On 5/27/2010, the VIX had a bigger hike than that of the infamous flash crash day. Since the Euro dropped significantly and entered the dangerous zone, the S&P lost 43 points that day. After the big rise of the VIX, the fear was relieved. Therefore, the market bottomed out and made a reversal.