In the Dugout: - The best way to see how to use the VIX

Though our lesson today deals with sentiment, I don't want anyone to get emotional about the subject. My feeble attempt at humor. Anyway, let's look at a popular sentimental indicator - the CBOE Volatility Index (VIX).

The VIX can be viewed on most charting programs, normally under the symbol VIX.X. The VIX is measure of a consensus volatility of the market over the next month. The VIX uses various options on the S&P 100 to create a hypothetical option that is always at-the-money and has exactly one month until expiration. The VIX has been shown to be an accurate predictor of future realized stock market volatility.

So you might be saying, "So what if it predicts future market volatility, how does it help me trade?" Good question, let's answer it. As you might have figured out already, sentiment looks at how people view the market. Many times, traders will use this information as a contrarian indicator. This means a trader might go short when the majority of traders are expounding on the profits to be made as the market heads higher. This goes along with the saying the majority of traders are right in the middle of a trend, but wrong at both ends.

As the VIX increases in value, it says there is more fear in the market. Fear comes into the market as traders start to throw in the towel. The thing to remember is that extreme fear normally occurs at market bottoms. This is because most people have already sold their holdings, leaving very few people left to sell.

The best way to see how to use the VIX is to compare the movement of the VIX to the market in general.

VIX Sept 14, 2000
"Chart generated by RavenQuote charting software. Copyright (C) 2000 #"

Notice how extreme levels in the VIX coincided with market tops and bottoms. As with any type of indicator, it is best to combine different types of analysis and several indicators to confirm where you think a stock or index might be heading, but using the VIX to note extreme levels in fear and complacency can help put the odds more in your favor.

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