Here we go again…
The stock market’s “crystal ball” is flashing another warning sign. Volatility Index (VIX) call options are much more expensive than the equivalent put options. And, as we’ve seen several times this year, whenever this condition exists, the broad stock market is vulnerable to a sharp and sudden decline.
The most recent example was back in early November, when I pointed out the VIX call options were more than 30 times more expensive than the puts. The S&P 500 was trading at about 2590 at the time. Three days later it dipped below 2570.
Regular readers know about the predictive power of VIX option prices. We’ve used extreme deviations in option prices before as a sort of “crystal ball” for the immediate direction of the stock market.
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 9.58. At that level, the VIX December 13 $10 puts are intrinsically worth $0.42. But they were offered at only $0.20. That’s a $0.22 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 $22 for every contract you traded. The European-style feature prevents that from happening – because you can only exercise the contract on the December 13 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 VIX December 13 $10 call options – which are $0.48 out of the money – closed Friday offered at $0.65.
In other words, traders were willing to pay more than three times the amount for an out-of-the-money call option on the VIX than an in-the-money put option. This tells 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 January 17 2018 $10 calls to the VIX January 17 2018 $10 puts. The calls closed Friday offered at $2.55, while the puts were only $0.15. (I use my trading quote system to track these prices, but you can find them at FreeRealTime.com.)
VIX calls are trading for 17 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 six 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 five straight times this year. I’m betting it will prove correct this time as well.
Best regards and good trading,
P.S. Powerful as they are, VIX option prices are just one of the tools on our belt.
In the Delta Report, we use a 17-point trading algorithm to find our low-risk, high-probability trades – no matter whether the market’s going up, down, or sideways.
If you’d like to learn more about my Delta Report system and how it works, click here.
In today’s mailbag, readers weigh in on the recent bank stock action discussed in Friday’s essay, “The Latest Mistake Traders Are Making”…
The other big reason for the rise in bank stocks last week was the relaxing of some of the regulations on smaller banks. The limit for meeting stringent lending and stress tests was raised from $50 billion in assets to $250 billion.
– Greg D.
Plus, on the Delta Report trade we made using these conditions…
Glad to see, right or wrong, you had the “stones” to give us this trade. I also know that your work gives this trade a higher probability of working.
It was not just a trade to have a trade. One can have smart, well-thought-out trades that meet technical analysis and parameters for a trade and still lose money. Tough game.
– Jeff W.
And one reader’s thoughts on the crypto bull market…
Do you think that there is a correlation between billions going into cryptos and the decline in gold? It seems strange that this has been so amplified this week.
– John B.
As always, feel free to send in your stories, questions, or suggestions right here…