Using the VIX as a fear gauge can help investors understand when institutions and big market participants are shifting their sentiment from the current market trend, and are beginning to take the opposite side of the order flow.
When we look to put money to work for our clients, the VIX is a good indicator of when we should buy dips and sell rips. Why is that? Because VIX helps tell us the health of liquidity in the market.
We know that markets typically fall fast and rise slow, and that the VIX should remain negatively correlated to the market. This makes sense: As the market drops, people scramble to buy protection, inflating options prices.
But when this relationship breaks down—when the VIX starts to move in the same direction as the S&P 500, or when the VIX stops rising quickly on down moves in the S&P 500—it can infer that a trend change is about to happen.
So what does it tell me that the VIX fell 25 percent off of a 3.4 percent rise in the market? It indicates that some traders are dipping their toes in the market by selling out their insurance (held in the form of puts).
This is encouraging, and tells me that if we can just push above resistance at the 50-day moving average, we might at least move to 1,650 in the S&P 500.
Normally, I'd love to see a retest of the lows while the VIX makes a lower high, and we haven't quite gotten that clear of a sign to buy into the market with a ton of conviction. However, Friday's move should at least put a pause in the recent selloff.