Interest in using the Chicago Board Options Exchange volatility index (symbol: VIX) as a sentiment indicator continues to grow. And some analysts use the VIX on almost a daily basis to support their opinions about which direction the stock market is likely to take.

Some analysts view the 200-day moving average on the VIX as indicative of normal option premiums. If option premiums are above the 200-day moving average, they are above the norm, or high; conversely, if option premiums are below the 200-day moving average, they are below the norm, or low. Using that logic, option premiums, as measured by the VIX, are currently low — well below the 200-day moving average.

Analysts view the VIX, which is often referred to as the “investor fear gauge,” as a contrarian indicator because they believe that individual investors are usually wrong at major turning points, so the market will probably move in a direction that is opposite to conventional wisdom. The question, then, is how to define the VIX in terms of sentiment.

To address that, we have to go back to the notion that the 200-day moving average is the norm. Readings close to the norm tell us nothing, whereas readings significantly above or below the norm indicate a particular sentiment. The prevailing wisdom says that readings below the norm are bullish; because this is a contrarian indicator, that would indicate a bearish sentiment or, at the very least, a defensive outlook. On the flip side, a reading above the norm would indicate bearishness among market participants, which means traders should be bullish.

But I am not convinced by that logic. To begin with, the VIX simply measures the level of option premiums on the S&P 500 composite index. Option premiums simply reflect risk, not market direction. Higher premiums imply nervousness among traders, whereas lower premiums indicate complacency.

There is a general consensus, however, on how one can use the VIX to predict market direction at extremes, or, as some like to define it, when there is a spike peak in the VIX.

As Lawrence McMillan, president of The Option Strategist (www.optionstrategist.com) in Morristown, N.J., once wrote: “All observers agree that when the market is crashing downward and volatility shoots up to a spike peak, it is an indication of massive fear among options traders. At such a time, put buying is driving the volatility higher. From a contrary point of view, if everyone is fearful, expecting the market to drop further, then there is no reason for fear, and the market should be bought.”

There are longer-term data that support this position, but in order to show it, we have to look at the original volatility index created by the CBOE — the VXO. The VXO, which has a longer track record, measures the level of option premiums on the S&P 100 index rather than the 500.

In examining a 10-year chart on the VXO, there are five points at which the VXO closed above 50, a level that is clearly defined as a spike peak. Furthermore, each of those spike peaks occurred at major bottoms in the S&P 500.

The problem is when analysts try to use the VIX as an interpretive tool when there is no spike peak — for example, believing that a daily VIX close below its 200-day moving average is bullish.

If you extend the spike peak argument to its logical conclusion, a low reading on the VIX implies that individual investors are bullish because they do not believe there is much risk in the market. But wouldn’t that lead to a bearish conclusion?

In fact, a low reading implies complacency, which means most individual investors believe the market is unlikely to do anything. As a sentiment indicator, that does nothing to help predict market direction. However, a low reading does provide a foundation for using the VIX as a volatility tool. When investors are complacent, believing that the market will probably remain in a narrow trading range, it usually does the opposite and makes a significant move, either up or down.

The strategy for an options trader is to buy volatility when there are low readings on the VIX. Specifically, buy short-term index straddles — say, two months out. A straddle involves the simultaneous purchase of a call and a put on the same underlying index. As a corollary, you could sell straddles when there is a high VIX reading — meaning when the VIX closes higher than normal, but not at the point at which one would call it a spike peak.

@page_break@Obviously, if we are to use the VIX as a market indicator, we need to have some way of knowing what is defined as a spike peak, what is considered a high VIX reading and what is considered a low VIX reading.

Generally, any reading above 50 is considered extreme, or a spike peak. A reading above 50 is probably the most reliable VIX signal, and the only signal with which one can decipher market direction. The problem is that there have only been seven readings above 50 in the past 15 years.

To consider the VIX as a sentiment indicator, we would have to find readings that occur more frequently. If we use the VIX 200-day moving average as a “normal” reading, then we would look for points above and below that mark. One way to do that is to overlay Bollinger bands on the VIX chart. The Bollinger bands define one standard deviation from the mean. And breaching a Bollinger band indicates a reading that occurs less frequently, but more often, than a spike peak.

If we use this as a tool, when the VIX breaks above the upper Bollinger band, it would be considered a high reading. And when it breaks below the lower Bollinger band, that would constitute a low reading.

We are currently at a reading that is on the lower Bollinger band — so make of that what you will. IE