Enter the VIX
Larry Connors, head of the Connors Research Group and author of the book “How The Stock Market Really Works,” determined that when the Chicago Board Options Exchange’s Volatility Index (VIX) reached extreme levels over several consecutive days, then the likelihood for a sharp reversal could be quantified with high accuracy, giving the trader a huge edge in trading the market (see “Revealing reversals”).
VIX is a measure of the level of implied volatility of a wide range of options on the S&P 500. This indicator reflects investors’ best assessment of risk as measured by short-term market volatility. The VIX will rise when fear is gathering in the market and fall as investors become euphoric, making it ideal as a predictor of short-term market volatility.
If implied volatility is high, the premium on options will rise and vice versa. As a result, rising option premiums reflect the rising expectation of future volatility of the underlying stock index, corresponding to higher implied volatility levels.
The VIX’s price movement is inverse of the S&P 500’s price action, so you want to watch and observe for extreme levels reached by the VIX. Because the market is dynamic, however, using the VIX alone, at best, would be incomplete. Due to its dynamic nature, it is essential to have another indicator that complements the VIX’s volatility, revealing when and where extreme levels are reached to help you prepare for entering the market.