The VIX, or CBOE Volatility Index, is often called the fear index, and it's an apt description but often for all the wrong reasons.
The VIX is a very useful guide to the expectation of significant change in the market. There are times, such as on September 14, when the source of the fear can be easily identified. The rapid decline in the VIX was a clear message that Janet Yellen would not raise interest rates at the FOMC meeting, and I made that call on on CNBC's Street Signs.
Readers have asked since why I forecast the Fed's decision not to hike with such confidence. The answer is, it starts with strong understanding of the VIX.
Technically it's a popular measure of the implied volatility of S&P 500 index options. The VIX is calculated by the Chicago Board Options Exchange (CBOE) and represents a measure of the market's expectation of stock market volatility over the mext 30-day period.
The key words are "expectation of volatility." It says nothing about the direction of said volatility. High VIX readings can be associated with both bullish and bearish conditions. As a measure of expected future volatility, the higher readings tell us that traders are anticipating an increase in market volatility, which is usually associated with a trend change.
The VIX by itself is not particularly useful. But combine the VIX with other chart analysis methods and the trader has a good idea of the direction of the volatility move i.e. it tells the trader about the direction of the trend change, or trend acceleration.
If I am long and an uptrend is developing then a high VIX reading is nothing to fear. If I am long and the market is showing some signs of end-of-trend behavior and the VIX gives a high reading, then I need to be fearful.
This takes us back to the recent VIX chart, which showed a dramatic decline is the VIX reading. What had the market been afraid of that drove the VIX to the previous highs? The upcoming FOMC meeting and the potential for an interest rate rise was the primary fear in the market. There was a high expectation of volatility and the consequent potential for a trend change or acceleration.
The, suddenly the VIX dropped. This gave a clear indication that the market did not expect a rise in interest rates. It expected the situation to remain unchanged. No need to volatility and mo need to anticipate a significant potential for trend change.
The VIX indicator gave traders the answer on what the Fed's move would be long before it became reality. The VIX, used properly, assists traders to anticipate the potential for significant trend change. Combined with other chart analysis methods it provides a significant trading edge, which is nothing to be fearful of.
Daryl Guppy is a trader and author of Trend Trading: The 36 Strategies of the Chinese for Financial Traders, available at www.guppytraders.com. He is a regular guest on CNBC Asia's Squawk Box and a speaker at trading conferences in China, Asia, Australia and Europe.