Volatility Index: Contrarian Indicator

According to an investor proverb, the time to buy stocks is when there is “blood in the streets.” The proverb has been attributed to Baron Rothschild centuries ago during the Panic of 1871 in Paris. During that time when everyone was selling, Baron Rothschild was buying.

Volatility Index, known also as the VIX, helps investors measure the blood in the streets. Peaks in the VIX are closely associated with market bottoms. That's because climaxes of fear are times when everyone who's ever going to sell has sold. And when all the sellers are out of the way, the buyers have the field all to themselves.

The VIX is a key measure of market expectations of near-term “volatility” conveyed by S&P 500 stock index option prices. Put simply, the VIX measures the degree to which investors think stocks will swing vigorously in the next 30 days. When option buyers are “fearful” that the S&P 500 index is going to have more large swings over the next 30 days, they will pay more for options contracts on the S&P 500 index to hedge their stock position. When option prices get inflated by expectations of high volatility, the VIX goes up. Hence, the VIX is often referred to as the "fear index”.

A study by Credit Suisse found that, after adjusting for market drift, high VIX levels correctly predicted a 5-month rally 63 percent of the time.

Typically, a VIX level above 40 is considered a sign of fear. Though, some analyst look for times when the VIX has risen above 35, and then he waits for the 20-day moving average of the VIX to turn down. That's an indicator that it’s time to buy.

Take a look at the peaks of the VIX in the previous global financial crises of October 1997, when the hedge fund Long-Term Capital Management collapsed in October 1998, and in the last bear market in October 2002. They were all terrific buying opportunities.

In the late summer of 1998, when hedge fund Long-Term Capital Management was imploding, the VIX had spiked up to mid 40s. Stocks went on to have a big rally in the fourth quarter of 1998 and through 1999.

In the months preceding the last bear market bottom in 2002, the VIX was few times above 40. That period was the height of the accounting shenanigans that shattered investor confidence; WorldCom filed for bankruptcy in July of that year.