Once again, VIX option prices are warning of trouble ahead.
We’ve received similar warnings four previous times this year. Following each one, the stock market pulled back hard.
It happened in mid-May, just before the S&P 500 suffered a one-day, 1.8% decline. It happened in mid-June when the market fell almost 3% over four days. It happened in late August when the S&P 500 rallied to new all-time highs, then reversed and dropped almost 30 points in the same day. And it happened in September, just prior to the S&P dropping 30 points intraday.
And it’s happening again right now. Call option prices on the Volatility Index (VIX) are significantly higher than put option prices.
Regular readers know about the predictive power of VIX option prices. We’ve used extreme deviations in option prices as warning signs before.
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, on Friday, the VIX closed at 9.14. At that level, the VIX November 8 $9.50 puts are intrinsically worth $0.36. But they were offered at only $0.10. That's a $0.26 discount to their intrinsic value.
If it existed on a regular, American-style stock option, you could buy the put, exercise it, and liquidate the position all day long – picking up $26 for every contract you traded. The European-style feature prevents that from happening – because you can only exercise the contract on the November 8 option expiration day.
Because of this unique pricing structure, VIX options provide terrific clues about where most traders expect the VIX to be on option expiration day.
The current VIX option prices tell us that even traders who are making bearish bets on the VIX expect the index to move higher over the next two days.
This sentiment is even more evident if you go out a little further and compare the VIX November 15 $9.50 calls to the VIX November 15 $9.50 puts. The calls closed Friday offered at $1.55, while the puts were only $0.05. (I use my trading quote system to track these prices, but you can find them at FreeRealTime.com.)
VIX calls are trading for 31 times the price of the equivalent VIX put options. So, VIX option traders clearly expect the index to move higher at some point over the next two 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 been right four straight times this year. I’m betting it will prove correct this time as well.
Best regards and good trading,
In today’s mailbag, we hear about readers’ strategies and successes in the gold and retail markets…
I make money in gold most months by selling puts on gold miners. I have two open positions now… I hope that I get put one or both. Then I would go the covered call route.
I am in several of your picks now. I look forward to your comments each day. New subscriber!
– Dennis F.
Thanks for the update. My junior miners are down the lowest in a year but they're bear market survivors and I'm sticking with them. Please keep us informed on buying into the dip.
– Laura S.
Cheers Jeff! I already closed a position of M based on your latest recommendation at a 30% gain in 10 days.
– Rafael T.
Do you have any past trading experiences that you’d like to share? How do you plan to trade the potential surge in volatility this week?
As always, write in your responses, questions, and comments right here.