No, I didn’t alter my genes to gain an unnaturally strong sense of smell. And no, I can’t really lock my jaws like a Pit Bull. I just look at the S&P 500 Volatility Index (VIX) and everything becomes clear.

What Is the VIX?

The VIX is a basic measure for volatility in the market. Higher levels of volatility in the market coincide with higher levels of fear. Higher levels of fear usually mean investors will pull money out of the markets and you see an overall drop in market value. So when you see the VIX rising, the market usually drops.

How Do You Use the VIX?

The best way to use it is as a tool to supplement your existing technical analysis.

Let’s say the market takes a huge drop one day. How do you know that this is the beginning of a genuine leg down? Sometimes it can be hard to tell. But if you look for a major technical break in the VIX to occur around the same time, the odds of you being right about that drop increase substantially.

A Major Opportunity in the VIX

Take a look at this chart to see the opportunity I’ve been talking about…

This is a three-year chart of the VIX. As you can see, it’s been marked by very clear support and resistance lines – one just under 20 and the other just under 40.

As you can see, the one just under 40 was tested earlier this year. More important, in the past few weeks it tested it again… and managed to close significantly above it.

At the same time, the Slow Stochastic indicator at the bottom of the chart (which is smoothed out over 14 weeks) is showing the VIX as oversold. Nearly every time the Slow Stochastic indicator has become oversold – meaning the red and black lines drop under 20 – the VIX went on to rise for the next ten to twelve weeks.

If the VIX is rising, that means the Dow Jones should be falling, possibly breaking under 8,000 sometime in the next few weeks and head towards 7,000.

The play should be obvious. But I’m going to point it out anyways because I’m feeling saucy.

If the Dow Jones drops under 8,000 as the VIX spikes, buy a put on the Diamonds ETF (NYSE:DIA), which is an ETF that tracks the value of the Dow Jones Industrial Average.

Well the sub-prime credit crunch is no laughing matter. But I still think it’s safe to say we’ve all had our fill of hearing about it. But analysts and economists are playing a similar Can You Top This? game. They’re trying to out-do each other with the biggest credit loss estimates imaginable. All we need is a “fear-o-meter” to gauge investors’ shock to these various estimates. Oh wait, we have one: It’s called the Volatility Index (VIX) which measures market volatility.

Last week the International Monetary Fund (IMF) weighed in with perhaps the most dismal loss estimates yet. According to the IMF’s numbers the sub-prime credit crunch may result in US$945 billion in expected losses and asset write-offs worldwide. Now I ask you: Who’s gonna top that?

Global financial firms have reported about US$245 billion or so (and still counting) in credit crunch losses so far. So the IMF’s data implies that the financial “pig” isn’t even one-quarter of its way through the credit crunch “python” yet!

If proved correct, the U.S. credit crunch would easily become the costliest financial crisis in history.

The previous holder of this dubious distinction is Japan, which suffered about US$750 billion in total losses during its “lost decade” of the 1990’s. In fact, the current sub-prime loss estimates make the U.S. Savings & Loan crisis of the 1980s and early ‘90s look like a drop in the bucket by comparison. That episode triggered losses of about 4% of U.S. GDP at the time. Today’s IMF estimate puts the total hit at about 7% of GDP.

More than half of the IMF’s loss estimate – equal to some US$500 billion – will be suffered by the banking sector. These hits are mainly confined to the U.S. and Europe where asset-backed securities proved to be the most popular (and toxic).

There’s a very large “fudge factor” in the IMF’s calculations however. About 76% of the total, or US$720 billion in estimated losses, will come from asset-backed securities of different kinds.

To arrive at that number, the calculations are based on distressed mark-to-market prices the IMF observed in mid-March. That was before the Fed’s “arranged marriage” of Bear Stearns with JP Morgan.

These distressed market prices for toxic, asset-backed paper may prove too pessimistic (along with the IMF’s loss estimates) if credit markets are able to recover. In the wake of the Bear Stearns deal, it’s clear the Fed is now willing to accept a wider range of securities as collateral for direct loans to banks. So credit conditions seem to be easing already.

Interest rate spreads on Credit Default Swaps for U.S. banks, which are basically insurance policies against another Bear Stearns like debacle, have fallen by as much as 40%. This means there is now less perceived risk in the financial sector. At the same time however, key short-term lending rates, such as London Interbank Offered Rate (LIBOR) rates, remain uncomfortably high.

The financial system is certainly not out of the woods just yet, that’s for sure. You can expect to see more shocking losses and asset write-offs from big banks over the next several weeks as first quarter reports are posted. It’s important to watch how markets react – financial shares in particular – to these announcements.

Remember, when stocks stop going DOWN further on bad news, that’s the first sign that the worst may have already passed. When stocks actually go UP on more bad news, that’s a strong indication investors are looking beyond the gloomy headlines, and toward an eventual recovery.

We may not be at that point just yet, as last Friday’s market slide will certainly attest. But we may be getting closer. The IMF says: Brace yourself for one-trillion dollars in sub-prime losses…can you top that?

MIKE BURNICK, Senior Editor & Global Markets Analyst

P.S. As banks around the world continue to suffer from what’s arguably the “worst financial crisis in history,” I’ll be hunting down ways to profit from the market slaughter with special put options. Click here to get in on my strategy before banks write-down another dime.