Volatility Based Sentiment Indicators for Timing the Markets

Abstract: VIX, published by the Chicago Board Options Exchange, is a well known implied volatility estimator. In this paper we assess its capability to be used as a sentiment indicator, and to give signals for a short term investment strategy. It will be proved and discussed how VIX-based strategies – also known as “Contrarian” strategies – can be effective as they lead to higher returns than the market. We also propose a purer sentiment indicator derived from VIX that gives more accurate market timing signals. We call this indicator “Net Emotional Volatility Index” (NEVI). It proves to have interesting properties, a highly significant statistical relationship with the market return, and a considerable power to time the market. The results of our back-testing for the period 2001-2002 and 2006-2007 using the two indicators are presented, compared and discussed. Possible explanations of the information that NEVI brings and why its signals work are provided.