On Wednesday, the S&P 500 closed at a new all-time high – above 3850 for the first time ever.
Technology stocks led the charge as the FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google) roared back to life after taking a few months to relax. And, speculators were once again jumping over themselves to buy call options, and bet on the stock market continuing higher.
But, the stock market’s crystal ball was screaming “BE CAREFUL!”
We haven’t looked into the crystal ball since late October. Back then, as the market was caught in a nasty selloff, the crystal ball said to buy the dip… It predicted stocks would be higher in the weeks ahead.
Two weeks later, the S&P 500 was 8% higher.
Then, when we looked into the crystal ball in late September, it told us to be careful… we could be headed for a rough month. The S&P 500 finished October 120 points below where it started the month.
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.
And right now, Volatility Index (VIX) call options are much more expensive than the equivalent put options. Whenever this condition exists, the broad stock market is vulnerable to a sharp and sudden decline.
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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 Wednesday, the VIX closed at 21.60. At that level, the VIX January 27 $23 puts were intrinsically worth $1.40. But, they were offered at only $1.00. That’s a $0.40 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 $40 for every contract you traded. The European-style feature prevents that from happening – because you can only exercise the contract on the January 27 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 January 27 $23 call options – which were $1.40 out of the money – closed Wednesday and were offered at $1.60.
In other words, traders were willing to pay more for a VIX call option that was $1.40 out of the money than for a VIX put option that was $1.40 in the money. This tells us that traders who are making bets on the VIX expect the index to move higher over the next week.
This sentiment is even more evident if you go out a little further and compare the VIX February 17 $23 calls to the VIX February 17 $23 puts. The calls closed Wednesday offered at $3.70, while the puts were only $1.85. (I use my trading quote system to track these prices, but you can find them at FreeRealTime.com.)
VIX calls are far more expensive than the equivalent VIX put options. So, VIX option traders clearly expect the index to move sharply higher between now and February 17. 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 a very good track record… I’m betting it’ll prove correct this time, as well.
Best regards and good trading,
P.S. VIX options are just one of the many tools I use to find winning trades for my Delta Report subscribers.
Just in the last few weeks, we’ve booked wins of 80%, 100%, and 140% using my trading toolkit. And, I think there’s far more profits to come.
In fact, just yesterday I recommended a trade in the telecom sector that I think has 130% potential in the next month. And, it’s still in my recommended range. To see how you can access it, just click here.
Have you profited from Jeff’s “crystal ball” predictions in the past?
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