Like lightning strikes, volatile markets can be scary. They can also be dangerous to most trading accounts — especially in the short term. But there is a little-known and under-appreciated mechanism that explains why price trends can change abruptly.

But you have to think like an options trader to use it.

Options traders are very familiar with volatility. That’s because volatility makes the options market run. The higher the volatility, the greater the odds of making money in options if you’re on the right side of the trade.

But stock traders look on volatility as if it were evil.

It’s not.

Today, I’ll describe how using a readily available measure of volatility can be useful in predicting the market’s direction.

What Is the CBOE Volatility Index?

The CBOE Volatility Index (VIX) is often called the “Fear Index.” The higher it goes, the more fear in the market.

Fearful markets are dominated by sellers, and the general price trend is down. When fear reaches an extreme — the hard part to measure — the down trend usually ends and prices either move sideways or begin to rise.

The usefulness of the CBOE Volatility Index as an analytical tool is often ignored because it’s not sexy.

I mean, who wants to look at the VIX when Tesla’s (NSDQ: TSLA) stock price is juiced by Elon Musk’s every tweet?

But the truth is that even Tesla’s stock price can be — and often is — affected by what happens in the VIX.

So what is the VIX?

Obviously, the VIX measures volatility, which can be roughly defined as the variability in stock prices.

But at its core, the VIX is a measure of the volume in put options, which are designed to rise in price when underlying assets fall.

The widely held belief is that a rise in put option volume is bullish for stocks. Traders often look for extremes in the put/call ratio to pinpoint when the market has turned.

But that notion is incorrect except during periods when the put volume is so high that it signals that sellers are nearly exhausted.

Yet in order to understand how rising put volume leads to a fall in stocks, it’s important to break down how the market works.

Fear and the Market’s Inner Workings

Traders buy put options as insurance against the falling prices of underlying assets, such as stocks. In order for a trader to buy a put option, they have to at least be concerned that a stock they own may fall in price.

When a trader buys a put option (a bearish bet), a market maker sells a put option to the trader (a bullish bet).

This transaction does not mean the market maker is bullish. It just means that the market maker has to make the transaction because the rules say they have to take the other side of the trade.

Most of the time, the market maker isn’t worried about making this transaction. That’s because they know the general order flow. And as long as the order flow remains bullish, the market maker will make money on the put option they just sold the concerned trader.

But if the order flow changes — meaning that sellers are starting to overwhelm buyers — the market maker is the first to recognize this important turning point. And at that point, they have to do something to protect their account.

So once the market maker notices the trend change, they start to sell stock index funds in order to reduce risk and hedge their put sales.

The sales of stock index futures by market makers then cause stock prices to fall. This fall in stock prices then causes increases in put option purchases, which prompts market makers to sell more index futures.

The longer this goes on, the worse the selling becomes. But at some point, the market maker recognizes that the sellers are becoming exhausted and that the buyers are coming back. Then the whole process reverses.

Thus, increasing put sales fuel a rise in the VIX, which then signals to the wider market that volatility is about to increase. The downward trend picks up speed as it becomes obvious that sellers are overwhelming buyers.

Where Are We Now?

The price chart below shows the relationship between the VIX (upper panel) and the S&P 500 (SPX, lower panel). Close scrutiny shows that a rise in the VIX is usually followed by a fall in the SPX. And when the VIX falls, the SPX tends to rise.

This inverse trend was very evident during the recent summer rally in stocks. The top in the VIX and the bottom in the SPX occurred almost simultaneously in June. Moreover, you can also see that the rise in the VIX in early August preceded the rolling-over of stock prices as the month progressed.

As I write, the VIX may be rolling over, as the 28 area seems to be a point of resistance. It’s still too early to know which way things will go. But it’s worth watching.

The 50-day moving average (blue line, upper panel) may be where the decision gets made. It’s a tough call right now, but what’s clear is that perhaps the put buyers are pulling back and the market makers are considering their next move.

The Bottom Line

Volatile markets are hard to trade. But what’s important is what’s happening inside the market, where the contest between traders and market makers unfolds.

The CBOE Volatility Index can be a useful tool in sorting out where the price trend may go next.

As I write, the VIX may be telling us that the down trend may reverse. But of course, it may not. That’s why I monitor this indicator on a very frequent basis.

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