The Volatility Index or VIX is a technical tool calculated and produced by the Chicago Board of Options Exchange, or CBOE since 1993. It is a contrarian-sentiment indicator derived by computing the implied volatility of eight call/put options on the S&P 100 index (OEX) with a mean expiration of 30 days.

Normally the VIX measurement is considered to give buying signals on stocks at market bottoms as it reaches the 30 level. The VIX area near 20 is likewise considered bearish territory with a near-term market top possibly in place.

This value-action drop towards 20 occurs as the broad market rallies and open interest on call options rises from bullish buying. As the call/put ratio becomes skewed towards the calls, it is suggested that overall sentiment is too bullish and new buying may become thin.

There is also the fundamental action of heavy call-option volume appreciating in value and being sold in the market at a profit. This unnatural weight towards one side of the balance forces market makers to short the underlying index to remain hedged, exerting downward pressure (resistance) on the S&P 100.

By the same token broad market selling sends the VIX rising towards the 30 mark as put-option buying increases beyond the norm. Heavy put-option volume being sold back into the market forces market makers to go long the index to remain hedged, giving upward pressure (support) to the S&P 100.

When the VIX reaches the 30 mark or its 20 range, buy/sell signals are almost always accurate within days of the mark. However, extreme market movement can jolt the VIX well out of its normal range to extreme high or low levels. We have seen the VIX drop to 16 and rise as high as 60+ intraday before the reversal occurred.

It can be said that the more extreme a VIX reading is outside the historical zone the greater magnitude a resulting price movement might be. An easy phrase to remember is, "When the VIX is high it's time to buy; when the VIX is low, it's time to go".

Below are some weekly and daily charts of the VIX index and Dow over the past few months. Notice the strong correlation between extreme moves in each:

(weekly chart of VIX)

We see that the VIX mostly trades within the 20 - 30 point range with occasional spikes outside. These are times to be prepared for serious price moves of great magnitude relative to recent trends.

(weekly chart - Dow)

(daily chart - VIX)

The daily chart of VIX demonstrates how the index began to move a bit erratically to the upside during recent major volatility in the broad markets. It has seemed to return once again to a more historical range.

(daily chart - Dow)

Waiting for points in time where the VIX breaks out of the normal trading range to buy or sell can result in substantial gains or preserved profits respectively.

CBOE's Market Volatility Index is a very accurate technical indicator when used in conjunction with other tools as well. Remember, no one indicator by itself can stand alone but do serve to complement each other for high-odds trading success.