Steve -- Could you give a brief explanation of the VIX and the put/call ratio as it relates to small investors? Thanks -- B.C.

Many people have become overly fascinated with the VIX, the CBOE Market Volatility Index. Maybe because dubbing it "the fear index" gives it a certain flair. Or maybe it's simply that people feel more comfortable trying to outwit the market and their fellow investors based on psychological warfare, rather than hunkering down in the trenches of fundamentals.

The VIX and put/call ratio are two of the most widely known -- and directly related to options -- measurements referred to as sentiment gauges. One pretty interesting Web site, sentimenTrader.com, tracks 60 such indicators.

The reason so much brain power is applied to researching and tracking this data is the concept that the two great forces driving stock prices are fear and greed. Based on the premise that the majority of people will be wrong at any given moment, extreme sentiment readings are used as contrary indicators. For a review of how the VIX is calculated, please see my earlier article on the subject.

What History Says

The 15-year range of the VIX has been between 20 and 30. So while the decline of 28% over the past six weeks to 24 is dramatic, I view it as simply a return to the middle of its historical range. I wouldn't use any current readings between 20 and 30 as any big tell about what direction the overall market might be heading.

Expanding on some of the points made in the above-referenced article, please note that the VIX has enjoyed great historical success. But it's a much more reliable indicator of marking market bottoms than calling tops. The VIX has traded above 40 in only 15 monthly periods out of 178 periods tracked since 1988, or just 8.4% of the time. Of those periods, the major indices have posted an average gain of 3% in the following month 73% of the time. And of the 13 times over the past seven years that the VIX exceeded 55, the market has rallied an average of 1.5% in the following two days 85% of the time.

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