There has been a lot of interest, and questions from readers, about how one might use volatility as a trading tool.

Given the interest and the rally in US stocks last week, this may be a good time to look at how we might use volatility as a trading tool.

At the moment, the most widely used gauge of volatility is the CBOE Volatility Index (symbol VIX). The VIX has long been used as a tool to measure investor sentiment, especially at extreme readings. The question of course, is what defines an extreme reading.

VIX is a sentiment gauge that most analysts view as a contrarian indicator. Believing that individual investors are usually wrong at major turning points.

A major turning point on the VIX being defined as a “spike peak.” Which is to say, the VIX spikes usually after a period when the market has fallen sharply. Contrarian theory says that when fear peaks sparked by excessive put buying, the market should be bought.

There have been three spike peaks during the last year. In each case, the VIX closed above 35. Of note, each of those spike peaks marked a short-term bottom in the S&P 500.

One of the challenges with this theory, is determining when a spike peak has occurred. If you look at longer term charts on volatility, there have been a number of spike peaks. But many of those occurred at much higher levels; above 50 and 60 in some cases. But when it is determined that one has occurred, it has almost always been indicative of a major market bottom.

In an effort to determine spike peaks, I overlay Bollinger Bands on the VIX. Bollinger Bands essentially create a one standard deviation envelope around a 20-day moving average.

Specifically, I look for a daily VIX reading that is significantly above the upper Bollinger Band, which I define as spike peak territory, and probably an indication of a market bottom.

I have included additional information on volatility trading tools in a more in depth article at www.m-x.ca/marc_options_articles_en.php in the Montréal Exchange’s site. Including how one might use Bollinger Bands as well as 200-day moving average crossovers, for directional trades and volatility trades.