Time for part two of our VIX series. This time we’re exploring how to use the VIX as a sentiment gauge. If you missed part one, read it here.

The Crowd

Humans are fickle, emotional creatures. Predicting the behavior of individuals is tricky. Stick ten different people from ten different walks of life in the same situation, and they’ll likely respond in different ways. But when one becomes two and two becomes three, well, eventually you have a crowd. And crowd behavior is much easier to forecast.

The classic example is yelling fire in a bustling theater. It doesn’t matter that the mass is comprised of individuals. Herd mentality takes over, and they panic, as one, for the exit doors.

Every day crowd psychology is on full display on Wall Street.

The Pendulum

What if you could measure the emotion or sentiment of the masses? Picture a pendulum in motion, swaying from left to right and right to left. One end represents fear, the other complacency. The pendulum is always moving, sometimes slow and sometimes fast. Emotions can only get so severe until they push back in the other direction.

And yet, fear is different than complacency. It comes in fast, is potent, and demands action. And, it usually exits as swiftly as it entered. When fear and panic crescendo, causing weak hands to throw in the towel and abandon their stocks, it is called a capitulation.

Complacency is slow, lazy, and lingers. Identifying when complacency has peaked is much harder than doing so with fear.

So how do you measure the feelings of the masses? Do you take a poll or make some phone calls? No! You follow the money. Watching what people do is far more revealing than listening to what people say. That’s one reason why polls are often poor sources for intel.

And what, pray tell, do traders do when they’re fearful? They buy insurance.

The Fear Gauge

The VIX measures investor demand for insurance. Here’s how it plays out:

Fear rises, demand for insurance rises, VIX rises

Fear falls, demand for insurance falls, VIX falls

To be more succinct, we could cut out the middle phrase, like so:

Fear rises, VIX rises

Fear falls, VIX falls

Because of this relationship, the VIX has become known as Wall Street’s fear gauge. When panic is in the air, you’ll see a slew of articles from CNBC to The Wall Street Journal pontificating on the latest VIX spike and its ramifications for asset prices.

Sentiment tools like the VIX are known as contrarian indicators. They help measure when the masses are too complacent or too fearful. Humphrey B. Neill, known by traders as the father of contrarian investing, said,

“The public is right during the trend, but wrong at both ends!”

That is to say, people become too optimistic or complacent at market tops and too pessimistic or fearful at market bottoms. It reminds me of another quote by the venerable Warren Buffett.

“You want to be greedy when others are fearful, and you want to be fearful when others are greedy. It’s that simple.”

The VIX allows you to quantify feelings, to measure emotions. It’s one thing to understand conceptually that you should be greedy when others are fearful, but how do you time that? Does the New York Stock Exchange ring a bell when fear enters the building?

Actually, yes!

The “bell” is a spike in the VIX index, and you’ll see them when the market suffers a sharp selloff. These VIX rips have a strong history of signaling tradable bottoms in the market. Hence the following, oft-quoted phrase:

“When the VIX is high, it’s time to buy; when the VIX is low, it’s time to go!”

Next time we’ll explore how to spot when the VIX is high, relying on historical examples to illustrate. Then, we’ll explore the suite of tradable products on the VIX like futures and options.

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