Jeff’s note: One quick thing before we get to today’s Market Minute…
Next Wednesday at 8 p.m. ET, I’m putting on a live training session with my son Carson, where I’ll teach him the trading techniques that allowed me to retire at 42. And, I’m releasing a free trade recommendation to all who attend.
It’s shaping up to be a truly special event, and I don’t want you to miss it. So, if you haven’t already, be sure to sign up for it right here.
Now, on to today’s insights…
By Jeff Clark, editor, Market Minute
On Wednesday, as the S&P 500 traded at a new all-time high, within pennies of 3400…
And as we witnessed a company hitting a $2 trillion market capitalization for the first time ever…
The stock market’s crystal ball was screaming… “BE CAREFUL!”
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 Wednesday, the VIX closed at 22.50. At that level, the VIX September 16 $26 puts were intrinsically worth $3.50. But they were offered at only $3.00. That’s a $0.50 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 $50 for every contract you traded. The European-style feature prevents that from happening – because you can only exercise the contract on the September 16 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 September 16 $26 call options – which were $3.50 out of the money – closed Tuesday offered at $3.50.
In other words, traders were willing to pay more for a VIX call option that was $3.50 out of the money than for a VIX put option that was $3.50 in the money. This tells us that traders making bets on the VIX expect the index to move higher over the next month.
This sentiment is even more evident if you go out a little further and compare the VIX October 21 $26 calls to the VIX October 21 $26 puts. The calls closed Tuesday offered at $6.00, while the puts were only $2.50. (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 October 21. And a rising VIX (meaning 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 will prove correct this time as well.
Best regards and good trading,
P.S. The volatility of the market has brought in a wave of new traders looking for the best way to make a profit during these turbulent times. And I know this firsthand… because one of them is my 18-year-old son Carson.
Carson currently has no trading experience, but he’s become fascinated by what I do each day. That’s why on August 26 at 8 pm E.T., he’ll try to double his money by trading options for big, short-term gains.
Click here to join me on August 26 at 8 pm E.T., and claim a free trade recommendation when you attend.
Have you ever made a profit from watching the VIX options “crystal ball”? Or is there another reliable trading signal you use?
Send us your thoughts – and your trading questions – to [email protected].
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