Low VIX isn't always a sell signal.
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But as a short-term tool, Larry McMillan of McMillan Analysis looks at the VIX this way: "When volatility is low, one cannot know whether the market will rise or fall -- only that it will be volatile."
There seems to be little disagreement over one fact: when volatility has spiked, as it did in 1987, amid the Asian crisis, and after Sept. 11, the market rises. But when volatility is low, "the market does not necessarily decline. It only does so about half the time," McMillan says.
Moreover, if volatility is low, investors get complacent, but they don't necessarily think the market is going up. Rather, they think it's going nowhere. Taken to its logical conclusion, a low volatility reading actually signals the public does not expect the market to move much in the near future at all.
Hopefully, this helps debunk the Wall Street myth that low volatility always precedes falling prices. Sometimes it does (especially in the last two years, where huge moves occurred), but most often it does not. Low volatility does precede a volatile market.
By extension, in low volatility periods, investors who traditionally run out and buy put options as insurance against a decline should consider buying straddles, which profit from big price swings in either direction.
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CSFB recommends buying one-month or two-month, at-the-money put options or put spreads on Texas Instruments, American Express, Bank of New York, Altera, Phelps Dodge, May Department Stores, UST, Gillette, FleetBoston Financial and Knight Ridder.
In a put spread, an investor buys one put and sells another put at a lower strike price. Both put options have the same expiration date.
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