The Volatility Index (VIX) triggered a sell signal on Friday by closing back inside its Bollinger Bands. Traders should now be on the lookout for a pullback in the stock market.

And, if you want to know how long the decline will last, then pay attention to the action in the VIX option prices.

Longtime readers know I often refer to Volatility Index (VIX) option prices as the “crystal ball” of the stock market. I don’t trade VIX options. The nature of how they trade (which I’ll explain in a moment) makes it too hard to consistently trade them for a profit.

But, I do pay very close attention to the pricing of VIX options – because they can tell us where the market is most likely headed next.

Let me explain…

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The VIX is a measurement of fear in the marketplace.

A high and rising VIX indicates that investors are scared and traders are bearish. A low and declining VIX indicates that investors are bullish and traders are complacent.

The VIX is a good contrary indicator, and it does help warn investors that the market is at extreme levels and vulnerable to a reversal. But, the VIX is not even close to being a crystal ball.

You see, the VIX does flash caution signs when the market gets a little too overheated to the upside or the downside. But the VIX doesn’t tell you how soon those trends are going to reverse, or how long that reversal will last.

So, trying to time a trade by watching the VIX is like driving on a road where the stoplights are timed inconsistently. One light might be yellow for five seconds before it turns red. The next light stays yellow for 20 seconds. Then, the next light might stay yellow for four minutes. It’s hard to drive on that kind of road. And it’s hard to trade by just watching the Volatility Index.

But watching VIX options, on the other hand… well, that’s more like having a crystal ball.

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, 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 13.28. At that level, the VIX August 21, $15 puts were intrinsically worth $1.72. But they were offered at only $1.25. That’s a $0.47 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 $47 for every contract you traded. The European-style feature prevents that from happening because you can only exercise this contract on the August 21 expiration day.

But, we can still benefit…

VIX options provide terrific clues about where most traders expect the VIX to be on option expiration day.

The current VIX option prices (as of Friday) tell us that traders expect the index to move higher over the next week. We know this because the price of VIX call options that expire on July 17 is significantly more than the price for similar VIX put options. At-the-money call options are basically three times the price of put options.

And, if we go out one month further, the VIX call options that expire on August 21 are five times the price of the put options.

For example, just compare the VIX August 21, $13.50 calls to the VIX August 21, $13.50 puts. The calls closed Friday offered at $2.65, while the puts were offered at $0.50. (I use my trading quote system to track these prices, but you can also find them here.)

In other words, even though the VIX puts are $0.22 in the money (meaning they have intrinsic value), and the VIX calls are $0.22 out of the money, the call options are trading for more than five times the price of the put options.

VIX option traders clearly expect the index to move higher over the next several days, and even higher still over the next month. And a rising VIX (rising volatility) usually accompanies a falling stock market.

Best regards and good trading,

Jeff Clark

P.S. If you’ve been reading Market Minute… If you’ve profited off the ideas presented here… If you’ve ever wondered where these ideas come from…

Or, if you’d like to know how I think traders will be able to profit from what I expect will be one of the most exciting market environments of the past decade… Then now is your chance to ask me anything. 

Please join me for a special Q&A session this Thursday at 2 p.m. ET. Normally, my Q&A sessions are reserved only for subscribers of Delta Report. But this time, because I think the stock market is setting up for a remarkable period of volatility – one that can be hugely profitable if you’re prepared for it – we’re opening up this Q&A session to Market Minute readers as well.

I urge you to take advantage of this opportunity and join me on Thursday. You can watch the Q&A when we go live Thursday right here… And, you can submit any questions you have right here