“Be fearful when others are greedy and greedy when others are fearful.”
As legendary investor Warren Buffet explained decades ago, markets are driven human emotion. Even with the creation of HFT algo trading programs, fear and greed still dominate market action. Fear is absolutely the most powerful emotion in the market and is reflected by changes in the Volatility Index (VIX).
VIX measures the markets expectation for volatility over the next 30 days by tracking a weighted measure of out of the money put & call options on the S&P 500. Professionals buy or sell large blocks of puts & calls to hedge their portfolios against market swings. For a mathematical understanding of how the Volatility Index is calculated see: VIX formula
A simple Volatility Index – VIX and S&P 500 overlay shows just how irrational markets can get in the short term. During the current bull market uptrend the VIX indicator has proven to be a helpful tool in risk management and high/risk reward positioning.
- VIX readings of >30 are associated with short term bottoms
- VIX readings of 25-30 have proven to be profitable entry points
- VIX readings of 18-25 are often areas of consolidation
- VIX readings of <18 are associated with short term tops