Stock, bond, and commodity markets all retreated last week. There were lots of reasons for the decline; the G-20 appeared to be headed to an impasse over global currency and trade problems, the EU failed to come to an agreement on its 2011 budget, and probably most influential, rumours that China may be poised to hike its key lending rate in the wake of 4.4% inflation in October.

Yet despite this anxiety, the option market appeared relatively immune to events. When the stocks markets sold off on Friday, volatility indexes turned higher. The S&P/TSX 60 Volatility Index, for example, climbed from around 16 in mid-October to just over 18 at Friday’s close. But both indexes remained at the lower end of their trading ranges. Leading one to ask; are investors too complacent?

It’s an important question, because sentiment has been so critical in determining market direction. And the distance between complacency and panic is not nearly as far as some would believe.

The back-tested historical S&P/TSX 60 Volatility Index is particularly instructive. When volatility is low, or at the lower end of its trading range, it typically foreshadows market sell-offs.

The problem is trying to gauge sentiment. Volatility indexes are valuable tools that can provide some back tested empirical evidence. But in reality, trying to predict when sentiment shifts from bullish to bearish, is like trying to predict when the Maple Leafs will win their next game.

Better to take a deep breath. If you are a Leafs fan, that means turning off the radio. If you are an options trader, it means hedge your bets. Like buying puts on broad-based exchange-traded stock index funds like the iShares S&P/TSX 60 Index Fund (TSX: XIU, recent price $18.36), or the iShares S&P 500 Index Cad Hedged (TSX: XSP, recent price US $13.80). Specifically, look at buying XIU December 18 puts at 28 cents, or XSP Dec 14 puts at US $0.50.