The Crystal Ball Has Turned Bearish

That should just about do it for the Volatility Index (VIX) broad stock market buy signal.

The VIX generated a buy signal two weeks ago when it first closed above its upper Bollinger Band, and then closed back inside the bands. The S&P 500 was trading at about 4990 at the time – roughly 130 points below its 50-day moving average (MA) line.

We speculated that the 50-day MA would be a good upside target for an oversold bounce. And, that target was hit last Friday – with the S&P 500 trading as high as 5135.

Traders who bought stocks two weeks ago on the basis of the VIX buy signal should lock in profits right now. Not only is the VIX now approaching its lower Bollinger Band, but also our crystal ball is screaming “be careful!”

The Predictive Power of the VIX

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.

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 13.49. At that level, the VIX May 15 $14 puts were intrinsically worth $0.51. But they were offered at only $0.40. That’s an $0.11 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 $11 for every contract you traded. The European-style feature prevents that from happening – because you can only exercise the contract on the May 15 option expiration day.

Because of this unique pricing structure, VIX options provide strong clues about where most traders expect the VIX to be on option expiration day.

Now, consider this…

It’s Bearish

On Friday, with the VIX trading below $13.50, the VIX May 15, $13.50 puts closed at about $0.10. Meanwhile, the VIX May 15, $13.50 calls closed at about $1.20.

(I use my trading quote system to track these prices, but you can find them at FreeRealTime.com.)

VIX calls are twelve times the price of the equivalent VIX put options. So, VIX option traders clearly expect the index to move sharply higher between now and May 15. And a rising VIX (rising volatility) usually accompanies a falling stock market.

So if you’re making short-term bullish bets, be careful. Just as the VIX buy signals have a very good track record, so too does the VIX crystal ball.

And right now, the crystal ball has turned bearish.

Best regards and good trading,

Jeff Clark
Editor, Market Minute