VIX - The Volatility Index
What is the VIX?
The first, and most important indicator of the condition of a stock market is the VIX - a Volatility Index. Essentially the VIX tells us how much variance there is in the expectation of future stock market prices. It is a measure of the size of the difference in (buy and sell) prices of a range of options (essentially bets on the future prices of stocks). In a way it is a measure of the stability of sentiment in the market, as it is based on the predictions (bets) that investors are making about future prices.
Cboe, the home of the VIX, describes it like this:
The Cboe Volatility Index® (VIX® Index®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, the VIX Index has been considered by many to be the world's premier barometer of investor sentiment and market volatility.
A low VIX (under 20) is good (for buying) - everyone is aligned in expectations, and the market is stable. A high VIX (over 30) is bad (from a risk averse perspective) - expectations are all over the place, and the market is unstable. In between 20 and 30 is a good time to sit tight, watch and wait for the right buying or critical selling conditions.
Slightly more technically, buying when the VIX is less than 20% means there is a 66.7% chance that the SPX will be within 20% higher or lower than its current value in the next year. (To get the expected change range for the next month, divide the VIX by 3.46).
Does it Work?
As you can see by the charts above, in general, when the VIX has been below 20 the SPX (the Standard and Poors 500 Index) has risen over time (the green arrows). On the other hand, when the VIX has been above 30, the SPX has fallen or stayed flat over time.
But note - it is not perfect, and the timing is not exact. For example, the VIX only rose above 30 after the SPX had already dropped by more than 200 points in February 2018 - see the chart snippet below:
The VIX is not perfect, but it is a very important indicator, especially used in conjunction with other indicators (e.g. the RSI, STO and A50R), to tell us about current market conditions. For the US stockmarkets I use Stockcharts to monitor the CBOE VIX (the $VIX indicator tag in Stockcharts). For Australia I simply google "ASX VIX".
I use the VIX together with other indicators to build my own market condition indicator - the Vandex.
For more information:
Wikipedia has a detailed explanation of the VIX.
Cboe is the official home of the VIX.
Investopedia has more easy to read detailed information.