In three of the last four months, Volatility Index (VIX) option prices have correctly signaled a quick decline in the broad stock market.
It happened in mid-May, just before the S&P 500 suffered a one-day 1.8% decline. It happened in mid-June when the market fell almost 3% over four days. It happened in late August when the S&P 500 rallied to new all time highs and then reversed and dropped almost 30 points in the same day.
And it’s happening again right now. VIX call option prices are significantly higher than put option prices.
I’ve written before about the predictive power of VIX option prices. 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 10.13. At that level, the VIX September 6 $10.50 puts are intrinsically worth $0.37. But they were offered at only $0.10. That's a $0.27 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 $27 for every contract you traded. The European-style feature prevents that from happening – because you can only exercise the contract on the September 6 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 current VIX option prices tell 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 September 20 $10.50 calls to the VIX September 20 $10.50 puts. The calls closed Friday offered at $2.20, while the puts were only $0.05. (I use my trading quote system to track these prices, but you can find them at FreeRealTime.com.)
VIX calls are trading for 44 times the price of the equivalent VIX put options.
VIX option traders clearly expect the index to move higher at some point over the next two weeks. And a rising VIX (rising volatility) usually accompanies a falling stock market.
So if you're making short-term bullish bets, be careful as we head into September.
Best regards and good trading,
P.S. How are you betting the VIX will come out of Labor Day weekend? Send me your thoughts, ideas, or suggestions right here.