I hear it all the time with the volatility index (VIX): "The indicator is broken" or "it doesn't work properly." Indicators such as the VIX are simply telling us where money is flowing at certain points in time. Hence, it is always working, it just may not be doing what people expect.
Recently we saw the VIX travel downward from elevated levels, let's call it 32%. That is an historically high reading - average readings on the VIX are in the 18%-20% range. Yet, not only was this fear gauge elevated, it stayed above 30% for a long period of time, some 12 sessions in a row before closing at 29% and breaking the streak. When the VIX starts coming down it's a clear sign of a risk on environment.
So let's talk about the VIX for a moment. This indicator simply tells us the demand for options - puts vs. calls - on the SPX 500. When demand is strong for puts then volatility is rising, and options are becoming more expensive as players seek protection from a potential market drop.
For most long term investors, it's not so much to hit the exits when volatility rises, rather it's an understanding of what is actually happening - panic and hysteria. Big moves in the VIX are often temporary and only last for a period of days, and then it falls. But some short term traders are even afraid of their own shadow, and are probably sellers at the first sign of trouble.
When there is a "risk off" day and it appears markets are going to be down - analyzing pre-market action and indicators - there is often a surge in the VIX, the indicator risings on demand for protection. But recently that has not happened during big down sessions. This past week was a good example. The evidence is there, market players are not pricing in uncertainty, which is the heart of the indicator.
The Fed? They're on a campaign to raise interest rates. How much will they go? It's hard to say, but when the VIX stays down during up sessions it clearly is telling us the chances of a surprise move are nil. Before you tell me that it makes no sense, I'm just telling you the message of the markets.
Bottom line, understand the role the VIX indicator plays in your trading and investing. Be mindful of large moves up and down within the context of the markets and other indicators, too.