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The Crystal Ball Sees Danger Ahead

The stock market ground to another new all-time high yesterday. The S&P 500 rolled right over the negative divergence that had built up on the intraday charts over the past three days, and closed at 2415. The bulls are in control. They have the momentum. The market can certainly press higher from here. But, I have to warn you… there’s danger ahead. Any further gains in the market in the short term are likely to be given back over the next few weeks.

The stock market ground to another new all-time high yesterday. The S&P 500 rolled right over the negative divergence that had built up on the intraday charts over the past three days, and closed at 2415.

The bulls are in control. They have the momentum. The market can certainly press higher from here.

But, I have to warn you… there’s danger ahead. Any further gains in the market in the short term are likely to be given back over the next few weeks.

Frankly, I’m starting to feel a bit like the robot in that old television show, Lost in Space. At the first sign of trouble, the robot would move around erratically, swing its arms, and chant, “Danger, Will Robinson! Danger!”

The danger for the stock market right now is forecasted by Volatility Index (VIX) option prices.

In late April, I published an essay describing how VIX option prices are a kind of “crystal ball” for the stock market. Back then, the S&P 500 was trading at an all-time high near 2390. Bulls were in control. They had the momentum. But VIX options were warning of danger ahead.

You see, the VIX call options that expired on May 17 were trading for a much higher price than the equivalent put options. Traders were willing to pay more than 10 times the price for VIX calls than for puts.

In my experience, when we’ve seen this sort of price discrepancy in the past, we just about always got a higher VIX by the time the options expired.

The monthly VIX option contracts expired on May 17 (VIX option expiration is different than standardized option expiration). Here’s a chart of the VIX for the days surrounding expiration day…

The VIX did nothing between April 27 and May 15. Then, on May 16 – just one day before option expiration – the VIX exploded higher by 50%. The crystal ball worked… again.

Here’s what happened to the S&P 500…

The stock market ground slowly higher between April 27 and May 15. During that time, I kept pointing to VIX option prices and warning, “Danger!” Then we got a 43-point, one-day correction in the S&P.

Since then, the stock market has recovered everything it lost and then some. The S&P has achieved my minimum upside target of 2411, and has pressed even higher. Just about everything looks bullish.

Except…

VIX options are at it again. The calls are far more expensive than the puts.

For example, yesterday the VIX closed just below 10. The VIX June $10 calls – which expire on June 21 – closed at $2.10. The VIX June $10 puts are offered for just $0.10. (I use my trading quote system to track these prices, but you can find them at quotes.freerealtime.com.)

In other words, VIX option traders are willing to pay 21 times more to buy calls on the VIX than to buy puts. VIX option traders clearly expect the index to move higher as we approach June expiration. And a rising VIX (rising volatility) usually accompanies a falling stock market.

That’s why, even though the market can certainly press even higher from here, any short-term gains are likely to be given back in the weeks ahead.

Best regards and good trading,

Jeff Clark

P.S. I heard from Delta Report readers who have been profiting off trades using my earnings algorithm… Right now, I’m preparing a full report on the strategy. If you’d like to know more, send me a note right here.

Mailbag

Got into your GES earnings trade. Bought calls yesterday at .90 when the stock was at $10.05. Looks like today the opening bid is $11.40 on the stock so I imagine the option will open with almost a double!! Also your APTI recommendation has paid for my subscription to Delta Report.

– D.R.

Nice job on the GES Trade! I made 100% return in less than 24 hours.  That’s an amazing ROI! Really looking forward to the “formal” roll-out of the earnings trade model. Seems like it works extremely well in “Beta”! Thanks again for your outstanding work.

– Tom

Thanks Jeff! Just closed out the GES earnings trade for a 100% gain in one day!! I wasn't able to get into TOL, but I also did well with your URBN recommendation. Thank you so much, look forward to more of these!

– Ryan