The Dow, however, dipped under its October 27 low of 8,176 while the S&P 500 Index was far below its 848.92 low last month.

The CBOE Volatility Index – which measures options traders’ sentiment on the S&P 500 Index – plunged 10% to 59.83. That’s still a highly elevated level with the VIX in record territory since Lehman’s collapse in mid-September. In 2008, the VIX has surged 113% and has gained an average 73% annually since November 2005.

An extreme VIX reading continues to suggest stocks are seriously oversold. Other market sentiment indicators remain highly stressed, including investment advisor sentiment (highly bearish), high cash levels at mutual funds and hedge funds and record equity fund and hedge fund redemptions. With everyone heading out the door at the same time over the last 60 days, contrarian investors believe stocks can post a major rally off the recent lows.

Since September 1, the Dow has crashed a cumulative 26% while the S&P 500 Index has plunged 32%. Worse, the MSCI Emerging Markets Index has collapsed, down a dizzy 42%. Over the same period gold prices have declined 10% while the euro has tanked 11.6%.

Just where the stock market is heading next is anyone’s guess. From one day to the next it’s like watching a wild rollercoaster; big price swings are indicative of a major transition ahead to either a bottoming process and then higher stock values, or worse, the next leg down for this bear market. It just seems that every time we have a big rally the sellers always tend to emerge.

I suggest investors remain highly defensive. It’s just not worth chasing this market. Remember, we are entering a “soft” economic depression as suggested by Swiss money-manager, Felix Zulauf. I embrace this view.

The economic news is still deteriorating and despite an oversold stock market, corporate earnings don’t look encouraging as global demand falls off the charts this fall. Any big rally should be viewed as an opportunity to sell unwanted stocks and raise shorts or reverse-indexing positions.

If you’re adamant about bottom fishing at these prices, consider going into the market carefully through income producing securities like bombed out convertible bonds, investment grade corporate bonds and TIPs. These are all highly attractive segments of credit right now and still miles below their highs following a major crash in September and October.

Source: Volatility Levels off the Charts

Under normal circumstances, the VIX goes up when the market declines and goes down when the market rises.

Over the past week though, the VIX has been behaving rather oddly. On Friday June 6, the VIX jumped over 26 percent as the market took its nosedive. Then, this past Wednesday when the Dow dropped another 200 points, the VIX was only up four percent.

On Thursday, the Dow was up 57 points and the VIX was down 3.3 percent.

As you can see this is not a perfect inverse relationship between the VIX and the overall market. I know I am comparing it to the Dow rather than the S&P, but the differences in the percentage movements are not that great.

Personally, I think the problem stems from the options on the VIX. A few years ago, the CBOE started offering options on the VIX. To my knowledge, only the hardcore traders are trading the VIX options.

I can say that since the introduction of VIX options, the VIX itself has become a less reliable indicator for me. I always thought of the VIX as a good gauge of overall fear in the market. When puts were being bid up more than the calls, the fear level was increasing and the VIX was rising.

I didn’t always use the VIX the way other traders do or did. My best moves based on the VIX were ones where the VIX jumped sharply or dropped sharply over a ten-day period. Anytime I saw significant, sustained moves in the VIX, almost without exception, a move in the opposite direction was certain.

These days, my old indicator doesn’t seem to work as well, and quite frankly, I don’t watch the VIX as closely as I used to. The reasons behind that could be numerous, but I think it has a lot to do with the options.

First of all, the VIX is a derivative of a derivative. This might seem confusing, but follow along if you would. A derivative is simply anything that derives its value from another underlying instrument. The options on the S&P that are used to calculate the VIX are derivatives. Now the VIX derives its value from those options, making it a derivative of a derivative.

Now you have the options on the VIX, which are derivatives of a derivative of a derivative. Say what?

When the VIX was initially introduced back in January 1990, the idea was simple…measure volatility. The calculations may not have been all that simple, but the concept was. Now some 18 years later, the value of the VIX is being influenced by the options that are traded on it.

The point is that the VIX has lost of its meaning for me. I still look at it occasionally and it still makes some rounds in the media. But for all intensive purposes, it has lost most of its value.

That being said, the VIX is currently hovering right around its 100-day and 200-day moving averages. The 200-day has acted as support in the past and is now acting as resistance. This could have some merit, more because investors are focused on it.

Now it may seem odd that would base an investment decision on an indicator that I have just been dismissing, but I am looking for a rally in the coming week or so. Part of it is based on the 200-day moving average of the VIX acting as resistance and the index falling. But more importantly, with the big sell-off on the June 6, and the pullback on Wednesday, the S&P has moved into oversold territory on the daily chart.