Here we go again…

The stock market’s “crystal ball” is flashing another warning sign.

Volatility Index (VIX) call options are much more expensive than the equivalent put options.

And, as we’ve seen a couple of times this year, whenever this condition exists, the broad stock market is vulnerable to a sharp and sudden decline…

The last time this happened was back in early June. The VIX call options were far more expensive than the puts, and the S&P 500 dropped over 100 points during the next few sessions.

We noted this same condition in late January. The S&P 500 fell nearly 200 points in the following week.

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 Friday, the VIX traded at 15.50. At that level, the VIX August 25 $16 puts are intrinsically worth $0.50. But, they were offered at only $0.25. That’s a $0.25 discount to their intrinsic value.

But, 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 $25 for every contract you traded. The European-style feature prevents that from happening – because you can only exercise the contract on the August 25 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 August 25 $16 call options – which are $0.50 out of the money – were offered at $1.10 on Friday.

In other words, traders were willing to pay more than four times the amount for an out-of-the-money call option on the VIX than an in-the-money put option. This tells us that even traders who are making bearish bets on the VIX expect the index to move higher over the next 12 days.

This sentiment is even more evident if you go out a little further and compare the VIX September 15 $16 calls to the VIX September 15 $16 puts. The calls were quoted on Friday at $3.80, while the puts were only $0.50.

VIX calls are trading for more than seven times the price of the equivalent VIX put options.

So, VIX option traders clearly expect the index to move higher at some point over the next month. 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 been right two times already this year, and I’m betting it will prove to be correct this time as well.

Best regards and good trading,

Jeff Clark

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