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Can be used at times to signal a bottom or rally, readings over 30 tend to show very bearish sentiment in options activity. Can be a good contrarian indicator
ABOUT THE VOLATILITY INDEX
By Nicholas Proffitt
The VIX is calculated by taking the weighted average of the Implied Volatility of 8 OEX calls and puts with an average time to expiration of 30 days. As such, it measures fear and optimism as manifested in OEX options activity. When large numbers of traders become fearful, the VIX reading rises, and when complacency about the market reigns, the VIX reading falls. And since the vast majority of put/call buyers are wrong and lose money, it's usually a smart move to fade (go counter to) what the VIX says the the crowd is doing.
The VIX is an INVERSE indicator, which means that high readings are oversold (excess of bearishness) and low readings are overbought (excess of bullishness). Because of this the VIX chart is displayed with an inverted scale to make its interpretation more intuitive -- overbought readings show at the top of the chart and vice versa.
Raw VIX numbers are of very little value. The VIX indicator is most useful when used in combination with some type of overlay, and preferably one that employs channels or bands. Some technicians use Bollinger Bands for this purpose, TraderNick uses a short term (3 months or so) linear regression channel, and for the Decision Point chart Carl has chosen 15% bands calculated from a 20-day EMA of the daily VIX close. When used in this fashion, it is the VIX position within the channel that's important, rather than the raw number reading.
The charts below show the wide range of the VIX over time and also show how the bands help define the limits of overbought and oversold under varied market conditions. Between December 1998 and June 1999 the VIX reading ran in a range between the low 20s to around the 30 level. Every time VIX hit the low 20s, the market was primed for a sell-off. And every time its snuggled up to the 30 level, it presaged a market rally. While the range during this period was between the low 20s and 30s, there were VIX readings as high as 60 and as low as 17 during the 12 month period beginning June 1998. On July 20, 1998, right at a market top that led to a 20% sell off, the VIX bottomed at 16.73. On Oct. 8, 1998, at the bottom of that bear move and the beginning of a powerful rally, the VIX put in a high of 60.63.
I learned about it on this thread...
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