Where to start looking for a market bottom with implied volatility.

Perspective is easily lost if all you do is watch one slice of the market. The whole picture can alert you to a lot. Not just when to be concerned, but also when to look for opportunities.

If you focused solely on the Russell 2000 small cap index, the following picture probably sums up your experience and expectation.

If all youve followed are large caps then the image below is probably your view, comparatively speaking.

In case you havent looked at either market this last year take a gander below. The S&P 500 ETF (left) and Russell 2000 ETF (right) are polar opposites.

Back to perspective. One way I look at the whole market is by examining implied volatility. This gives a sense of fear by directly measuring expectations of those with money on the line.

Specifically, I combine all of the volatility indexes for the major US equity indexes, creating a composite of volatility/fear for the entire US Market. I can compare that composite VIX to the Wilshire Total Market Index, which measures the performance of all U.S. equity securities with readily available price data.

So what does this fear composite look like? In the chart below, the Wilshire is in the top pane while the VIX composite is below.

Peaks in the VIX composite mostly match to bottoms in the Wilshire. Having a good estimate of what level volatility/fear is likely to have run its course would be very useful. I wrote an algo that does just that. You can read more about specifics here.

The last real-time peak in fear, shown with red arrows, was detected on 10/10 and 10/13. Other peaks were detected in late-January and mid-April. Results of this approach on the VIX can be seen here.

So what can we infer from this study? For starters, I would look for a peak if the VIX composite neared 120. This is the level that the algo would tag as a likely extreme. That would translate into a likely bottom in the market, being around the corner.

Can a bottom in the market happen without volatility reaching 120? Absolutely. Can volatility reach 120 and continue higher? Absolutely. Unexpected/underestimated world events, black swans and those other pesky unknown unknowns keep us on our toes. That said, the odds of a peak in volatility occurring if volatility reached that level and the market being higher 1 year later are 68%.

Just as useful, though, would be volatility settling back down below 67. Volatility remaining over that number would imply that traders are still expecting elevated levels of chop to continue.

I will continue to monitor these and other unique perspectives here. You can also follow me on twitter and stocktwits via @carsondahlberg.