We’ve introduced you to the VIX Index, and discussed how to use it as a sentiment gauge. Now it’s time to dive deep into the signals I use on the VIX to determine when fear is thick and its time to be a contrarian.

This is part three of our ongoing VIX series.

Last week’s commentary ended with the following phrase:

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

Today I’m going to show you how to put the theory into practice.

What is High?

The terms “high” and “low” are relative. What’s high for one asset might be low for another. When it comes to VIX here are the levels I would identify as high. Here’s some historical context of the highest VIX readings:

It’s interesting that with every crisis but the 2008 massacre, the VIX peaked in the upper 40s. Don’t expect the VIX to visit these levels often, but when it does there is no doubt that the masses are panic and fear is thick.

Takeaway #1: A VIX reading in the upper 40s screams mass panic and a bottom in stocks is likely imminent.

Application #1: Set an alert on the VIX at 40, that way you’ll be notified if and when mass panic hits.

The problem with waiting for a reading north of 40 is it only happens once every few years. So it’s not as useful if you’re looking for garden-variety panics and not world-ending ones.

Here’s another level worth watching: 30.

Historically, a push above the 30 level in VIX is unsustainable. The two major exceptions were 2009 and 2011. In both instances, VIX remained north of 30 for 8 months and 4 months, respectively. So it’s not impossible, just rare.

Takeaway #2: Most VIX spikes above 30 will revert lower quickly.

Application #2: Set an alert on the VIX at 30. When alerted, review your Market Panic Playbook and respond accordingly.

Though the 30 level is visited more often than the mid-40s, it’s still uncommon. My final method for identifying when the VIX is high is the most sensitive and will provide the most signals. It involves using the Bollinger Band indicator.

Bollinger Bands

Bollinger bands are an adaptive volatility envelope designed to identify extremes in price movement (i.e. when price is overbought/oversold). They are adaptive because the distance between the bands expands and contracts as volatility increases or decreases. They are an “envelope” because they are plotted around the stock price thus enveloping the price.

When the VIX spikes above the upper bollinger band it is a sign that the Index is high. Because the bands track the stock price somewhat closely, you can see a push above the upper band whether the VIX is sitting at 10, 15, 20, 30, or whatever. It thus provides more frequent and timely signals.

Takeaway #3: Most VIX spikes above the upper bollinger band will revert lower within a few days.

Application #3: Create a chart style that has the bollinger bands and price. Remove the moving averages and any other indicator to clean up the chart. When the VIX pushes above the upper band, a short-term (and potentially long-term) bounce in stock prices is likely.

Market Panic Playbook

Now that you know how to identify when the VIX is high, it’s time to talk about what to do when such signals arise. Consider this an abbreviated version of what could be a much larger Market Panic Playbook.

First, remember the implication of a high VIX reading. It suggests a pivot low and sharp rebound in the market is looming. I can think of three actions to take.

Action #1: Tighten stops and/or take profits on bear trades. Now is not the time for greed little piggy. You probably just made a mint on your bear trades so ring the register and harvest those gains. Otherwise, you’re liable to give back profits when the snapback arrives.

Action #2: Avoid entering new bear trades, unless you’re day trading and have a tight leash. You don’t want to be the shmuck that shorted into the hole and got squeezed on the way back up.

Action #3: If you’re comfortable being a contrarian, sell puts or bull puts to bank on the sky-high implied volatility and likelihood of a market bounce.

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