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Traders should be careful right here. Our crystal ball is warning of trouble ahead.
It has been three months since we last peered into the crystal ball. Back then, the S&P 500 was trading at an all-time high. The “military conflict” in Iran was rumored to be near an end. And, just about all the financial television talking heads were screaming, “BUY BUY BUY!”
But, our crystal ball told us it was time to sell.
The S&P 500 lost 5% over the next two weeks.
So now, with the S&P 500 once again nearing an all-time high, with the Iran situation now placed on the back burner, and with just about all of the financial television talking heads once again leaning bullish, it’s a good time to take another look at our crystal ball.
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.
Right now, the prices of VIX option contracts are suggesting a higher VIX over the next few days, and the next few weeks. And, a higher VIX usually goes along with a lower stock market.
For example, yesterday, as the VIX was trading at 14.60, the VIX September 2 $15 calls were trading for $0.90. Meanwhile, the VIX September 2 $15 puts were trading for $0.10.
In other words, VIX calls – which were $0.40 out of the money – were trading for nine times the price of VIX puts, which were $0.40 in the money.
VIX call options are much more expensive than the equivalent put options. This suggests the VIX will be higher next Wednesday than where it was yesterday.
This is an extreme price difference.
When we’ve seen this condition before, it has usually resulted with the VIX moving higher and the stock market moving lower in the short term.
If we go out a bit further in time, the picture is even more bearish. The VIX September 16 $15 calls traded yesterday for $2.05 while the equivalent put option was $0.12.
Traders were willing to pay 17 times the price to bet on a higher VIX by mid-September than they were to bet on a lower one.
There’s no question – the crystal ball is leaning in the bearish direction.
Add to this the bearish seasonality our contributing editor Mike Burnick pointed out yesterday and you have the setup for a stock market decline that will catch most traders by surprise – or, at least the traders who don’t know how to use the crystal ball.
Best regards and good trading,
Jeff Clark
Editor, Market Minute