Using The Options Volatility Index (VIX) To Determine Short Term Market Direction.

The VIX as is commonly known, (Or Chicago Board Options Exchange Volatility Index), is a popular measure of the implied volatility of S&P 500 index options. Simply put, this VIX index is a measure of investor nervousness, it rises as markets fall and falls as markets rally. When its value is too high investors consider it a strong sign of uncertainty and option premiums are much more expensive than when it is at low levels and investor confidence is high.

Trying to make sense of the VIX indicator is difficult and certainly its absolute value is not of much use in day to day trading. The VIX however is a mean-reverting index which has a high tendency to regularly deviate from and revert back to its 10 day average, So the concept is to compare the absolute value of the VIX index to its 10 day average and work out a % figure as a threshold level to make trading decisions upon.

If for example the market has been rallying for a number of days and the VIX has deviated extremely down from its 10 day average it is a statistical certainty that very soon it will rise back to its 10 day average and most likely make a new high above this average, which means markets will be correcting to the downside while all this happens.

The best method for making sense of the VIX in order to figure out the most likely market sentiment for short term, 3-7 days outlook is to use this simple formula:
((VIX value) / (10 day average of VIX))-1) X 100 and a threshold level of around 7%.

For example if VIX is say 27 after a given days close, and the 10 day average is 30.

We see that it’s a relative drop of 10% , VIX is 10% below its 10 day average and an end to the market rally is well expected. The idea in this case would be to go short the market and wait until the above formula gives at least 7 , (from -10 to go to 7 or more). Then a new rally would be expected. There’s no exact science to describe investor fear and greed, however in any given market trend, this simple indicator can tell you the exact day where you should consider at least tightening your stops and question the validity of your trade’s criteria.