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Chartist to Cramer: VIX has crucial red flags

Trader on the floor of the New York Stock Exchange.
Lucas Jackson | Reuters
Trader on the floor of the New York Stock Exchange.

Jim Cramer wonders if he is being too optimistic because he thinks the best thing for investors to do amid the market selloff is to simply stay the course.

Cramer thinks that the market is closer to the bottom than many would believe, but Mark Sebastian does not agree. Sebastian, the founder of OptionPit.com and colleague of Cramer's at RealMoney.com, thinks you should be very scared.

"When Mark talks about fear, we take him seriously because he's our resident expert on the CBOE Volatility Index," the "Mad Money" host said.

The volatility index is also known as the VIX, or fear gauge, because it is often used to measure the overall level of terror in the stock market.

Sebastian is worried because of the waving red flags he is seeing in the VIX; he thinks many professional VIX watchers are underestimating the danger since the VIX has been so placid in the past three years.

The main concern is something called recency bias, where people assume that trends from the recent past are permanent and will continue into the future.

Looking at the charts of the S&P 500 and the VIX going back to 2012, spikes in the VIX have been small. Thus, whenever the VIX has spiked, the S&P quickly bottomed and had a nice V-shaped recovery. Looking at this chart, one would assume that all spikes in the VIX are buying opportunities.

But looking further back, on a longer time horizon, Sebastian saw something very different. He pointed out that since 2005, whenever the VIX surged over 40 something horrible has happened to the stock market. And while the VIX closed at 30 on Monday, it broke out above 40 in the morning and traded as high as 53 before the market started rebounding.

"When the VIX breaks out above 40, Sebastian says you need to sell everything and run for cover, because the history shows that you will lose if you own stocks," Cramer said.

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Ultimately, Sebastian believes that this selloff is not like the other declines that the market has seen in recent years—he believes that it has the potential to be worse.

"As for me, I think that view is too negative. I'm much more sanguine than Sebastian, but I wouldn't be doing my job if I didn't bring his cautionary tale to your attention, and I respect his work enough that I'm not saying to buy with both feet," Cramer added.

Cramer advised to leg into high quality stocks as they go lower and take your time. Let the stocks come down to the price you want, and respect the downside.

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