The stock market has fallen for four straight weeks. The S&P 500 topped just above 3500 in late August. It closed just below 3300 on Friday. But, Friday’s 51-point rally in the index has lots of folks thinking the short-term correction is over.

Think again. After all, here comes October.

October can be a tough month for the stock market. And, if we look at the price action in the Volatility Index (VIX) options this coming October, it’s going to prove tough as well.

Let me explain…

Regular readers know that VIX options are European-style contracts – meaning they can only be exercised on option expiration day. This unique feature 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 near 26.40. At that level, the VIX October 7 $28 puts were intrinsically worth $1.60. But, they were offered for only $0.60. That’s a $1.00 discount to their intrinsic value.

If this existed on a regular, American-style stock option, you could buy the put, exercise it, and then liquidate the position immediately – picking up $100 for the contract you traded. The European-style feature of VIX options prevents that from happening; because you can only exercise the contract on the October 7 option expiration day.

Because of this feature, VIX options provide clues about where the VIX is likely going to be on option expiration day. And, that gives us an idea of whether the stock market is more likely to be higher or lower.

On Friday, when the VIX closed at 26.40, the VIX October 7 $28 call options – which were $1.60 out of the money – closed at $3.30.

In other words, traders were willing to pay more than five-times as much for a VIX call option that was $1.60 out of the money than for a VIX put option that was $1.60 in the money. That tells us that traders making bets on the VIX expect the index to move higher over the next ten days.

And, a higher VIX usually goes along with a lower stock market – especially during the month of October.

We noted a similar discrepancy in VIX option prices in late August and in early September. And, we’ve seen the stock market fall for the past four weeks.

Friday’s bounce in the market probably has another day or two to go to keep stock prices pressing higher into the end of September. But, the VIX option prices are warning us of more trouble ahead.

We could see another rough October.

Best regards and good trading,

Jeff Clark

Reader Mailbag

Do you regularly follow the VIX indicators on which direction the market will move next? If so, do you agree with Jeff’s prediction that the market is heading for a difficult October?

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