Editor’s note: Since Jeff is traveling today, we wanted to share an essay that details an important indicator Jeff has been using this week: the Volatility Index and its options.

We’ll be back with an original Market Minute tomorrow morning.

[This essay was originally published on April 27, 2017.]

In today’s Market Minute, I’d like to share an idea that can make you a better trader.

It's the one indicator I follow more than any other when I want to know where the stock market is headed next. It’s a twist on a commonly followed market indicator… the Volatility Index (VIX).
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. Some traders even refer to the VIX as a “crystal ball for the stock market.”

That’s a bit of an exaggeration. 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.

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 a better crystal ball. 

VIX options are difficult to trade. The half-dozen or so times I tried were all disappointing. It didn't matter if I got the direction right. It didn't matter if the VIX moved far beyond my upside or downside targets – it is remarkably difficult to profit trading options on the VIX.

But watching them trade can make it far easier to profit on the rest of the stock market.

Let me explain…

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 Tuesday, April 25, the VIX closed at 10.76. At that level, the VIX May 17 $12 puts were intrinsically worth $1.24. But they were offered at only $0.60. That's a $0.64 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 $64 for every contract you traded. The European-style feature prevents that from happening – because you can only exercise this contract on the May 17 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 tell us that even traders who are making bearish bets on the VIX expect the index to move higher in May. This sentiment is even more evident if you compare the VIX May 11 calls to the VIX May 11 puts. The calls closed Tuesday, April 25 were offered at $1.50, while the puts were only $0.15. (I use my trading quote system to track these prices, but you can find them at quotes.freerealtime.com.)

So, VIX calls are trading for 10 times the price of the equivalent VIX put options.

VIX option traders clearly expect the index to move higher in the short term. And a rising VIX (rising volatility) usually accompanies a falling stock market

Watch the VIX for signs of investor fear or complacency that can lead to a trend reversal.

But pay closer attention to VIX options. They’ll improve your timing on reversal trades.

Best regards and good trading,

Jeff Clark

Reader Mailbag

In today’s mailbag, we hear how one reader is using the action in VIX options to their advantage…

Thanks for Monday's warning/advice of how a low VIX means imminent volatility and temporary price pullbacks. I know it's not certain, but it's very helpful, as I have several stock buy limit orders awaiting a hit at a lower-end price. Your info, combined with Bollinger Bands and other technical indicators allowed me to set a lower limit than I'd otherwise set.

Please let us know if the VIX situation changes and you no longer expect a temporary market pullback, as I'd need to raise the prices somewhat. I can't monitor stocks and changes prices every work day, so must guess a good place to buy or sell using limits good till cancelled.

–  Tim G.

How have you profited from watching VIX options in the past? Send in your thoughts, along with any questions or suggestions, right here