A RISING VIX
Extreme emotions such as fear and greed birth extreme price movements. Another way to say that is that prices are more volatile when there is a greater-than-average amount of fear or greed in the market. In a market crash, fear is the dominant emotion and it feeds on itself, creating a feedback loop of plunging prices and increasing fear.
If we could measure the amount of price volatility in the market, we could have a better sense of the likelihood of a fear-driven event such as an impending crash. Fortunately, we have an objective way to measure volatility: the Volatility Index, or “VIX”. This index measures the magnitude of volatility in prices. The higher the VIX, the greater the degree of volatility in the market, which means the market is more prone to extreme price movements.
When the dominant emotion in the market is confidence, the VIX is low and price changes reflect that confidence by being fairly stable. When the dominant emotion in the market is fear or greed, the VIX is high and price changes tend to be more volatile.
So the first sign to watch for an impending crash is an increase in the VIX, which signals an increasing amount of extreme emotion in the market. The best way to do that is to chart the VIX and compare its price to its long-term average. If the price of the VIX is is rising, then price volatility is increasing. If the price of the VIX is above its long-term average, then price changes are more volatile than average. Combine those two – a VIX which is rising AND is above its long-term average, and you have a market which is ready to do something shocking.
VOLUME CONFIRMING PRICE
A rising VIX means extreme emotions in the market are increasing. But just knowing that volatility is increasing isn’t enough to tell us whether the dominant emotions are FEAR or GREED. The simplest way to determine which of these emotions is dominant is by checking Price & Volume.
When price changes occur on falling volume or lower-than-average volume, this indicates a lack of conviction. In other words, there is no strong emotion attached to such price movements. But when price changes are accompanied by rising and higher-than-average volume, this indicates more conviction, which can translate easily into more emotion.
There are two combinations of PRICE/VOLUME which can signal the onset of a crash. The first is a rising price accompanied by below-average volume and falling volume. This means that the conviction of buyers is drying up, and that there are fewer buyers willing to commit funds at higher prices.
An even more powerful signal of an impending crash is a bigger-than-average price drop on higher-than-average volume. This is a reliable signal that fear is entering the market and you should be ready to exit your long positions.
Note, however, that a big price drop on average or lower-than-average volume usually means that sellers are not motivated to close their positions, which means that – in spite of the price drop – there is an absence of fear in the market.
OTHER SIGNS & SYMPTOMS OF AN IMPENDING CRASH
When you have a jittery market, (as indicated by the VIX and the VOLUME/PRICE combo, an event external to the market can trigger a crash. Examples of this are the terrorist attack in September 2001, the runup to the Iraq war in 1992, and the passing of the Smoot-Hawley Tariff Act in 1930. (Though passed in 1930, the prospects of the Act being passed in 1929 spooked the market and was a significant contributing factor in the 1929 crash. See http://www.polyconomics.com/index.php?option=com_content&view=article&id=2309:-75th-anniversary-of-smoot-hawley-tariff-act&catid=44:2005&Itemid=30).