A Warning Sign for Market Bulls

June has been an excellent month for the bulls.

Heading into the last day of trading for June, the S&P 500 is up 4.6% for the month. The NASDAQ Composite Index is up 4.9%.

And, it sure seems like just about everyone is expecting those gains to continue into July.

I’m not so sure. And neither is the crystal ball.

Let me explain…

The Volatility Index (VIX) traded at $13.50 yesterday. That’s near its lowest level of the year.

Since the VIX is often viewed as Wall Street’s “fear gauge,” it’s safe to say that investor complacency is near its highest level of the year.

But, that may be about to change.

VIX option prices are suggesting the VIX is headed higher next month. And, a higher VIX usually goes along with a falling stock market.

Long-time readers know we look to VIX option prices as a kind of “crystal ball” to the stock market.

You see, VIX options are not like most stock option contracts, which can be exercised at any time.

VIX options are European-style contracts – meaning they can only be exercised on option expiration day. This eliminates any possible “arbitrage” effect (the act of buying an option, exercising it immediately, and then selling the underlying security for a profit).

So, VIX options will often trade at a discount to intrinsic value.

For example, yesterday, the VIX was trading near 13.50. At that level, the VIX July 19 $15 puts were intrinsically worth $1.50. But, they were offered at only $1.00. That’s a $0.50 discount to their intrinsic value.

If this put existed on a regular, American-style stock option, you could buy it, exercise it, and liquidate the position all day long – picking up $50 for every contract you traded.

But the European-style feature prevents that from happening because you can only exercise the contract on the July 19 option expiration day.

Because of its unique pricing structure, VIX options provide terrific clues about where most traders expect the VIX to be on option expiration day.

As I mentioned above, the VIX traded at 13.50 yesterday. The VIX July 19 $13.50 call options were offered at $2.00. Meanwhile, the VIX July 19 $13.50 puts were offered for $0.27.

In other words, traders were willing to pay more than seven times the price for a VIX call option than for a VIX put option.

This sentiment is just even more evident if you go out a little further and compare the VIX August 16 $13.50 calls to the VIX August 16 $13.50 puts. The calls were offered yesterday at $3.30, while the puts were only $0.30. (I use my trading quote system to track these prices, but you can find them at FreeRealTime.com.)

When VIX calls are far more expensive than the equivalent put options, it shows VIX option traders expect the index to move sharply higher over the next several weeks.

And a rising VIX (rising volatility) usually accompanies a falling stock market.

So, if you’re making short-term bullish bets, be careful.

The VIX “crystal ball” has a very good track record… I’m betting it’ll prove correct this time, as well.

Best regards and good trading,

Jeff Clark

Are you prepared for a market correction?

Let us know your thoughts – and any questions you have – at [email protected].