Randy Frederick

   

I've been skeptical about the value of this indicator and these sentiment levels for years, yet you'll find many traders who believe in them. From my own research, I've found that when the VIX hits extremely high levels (indicating extreme uncertainty) or extremely low levels (indicating extreme complacency), the market will often reverse directions.

The problem with measuring extremes, however, is that they're all relative. A VIX level of 20 would have been considered extreme in 2005 or 2006, but so far in 2008, it has been at the low end of the range.

In fact, as you can see in the weekly VIX chart below, for virtually the entire period from late 2003 until mid-2007, the VIX was below 20. During this time, however, the broad market, as indicated by the SPX (pink line), was in a solidly bullish trend. Any option trader betting that the market would break down at some point (since the VIX was moving deeper and deeper below the 20 line) has probably been wiped out by now.

So what's an option trader to do? There must be something else we can watch to get a sense of where we are headed.

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