Long-time readers know I often refer to Volatility Index (VIX) option prices as the “crystal ball” of the stock market. I don’t trade VIX options. The nature of how they trade (which I’ll explain in a moment) makes it too hard to consistently trade them for a profit.
But, I do pay very close attention to the pricing of VIX options – because they can tell us where the market is most likely headed next.
Let me explain…
The VIX is a measurement of fear in the marketplace.
A high and rising VIX indicates that investors are scared and traders are bearish. A low and declining VIX indicates that investors are bullish and traders are complacent.
The VIX is a good contrary indicator, and it does help warn investors that the market is at extreme levels and vulnerable to a reversal. But, the VIX is not even close to being a crystal ball.
You see, the VIX does flash caution signs when the market gets a little too overheated to the upside or the downside. But the VIX doesn’t tell you how soon those trends are going to reverse.
So, trying to time a trade by watching the VIX is like driving on a road where the stoplights are timed inconsistently. One light might be yellow for five seconds before it turns red. The next light stays yellow for 20 seconds. Then, the next light might stay yellow for four minutes. It’s hard to drive on that kind of road. And it’s hard to trade by just watching the Volatility Index.
But watching VIX options, on the other hand… well, that’s more like having a crystal ball.
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, then selling the underlying security for a profit). So, VIX options will often trade at a discount to intrinsic value.
For example, on Monday, October 15, the VIX closed at 21.30. At that level, the VIX October 24, $19 calls were intrinsically worth $2.30. But they were offered at only $2.00. That’s a $0.30 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 $30 for every contract you traded. The European-style feature prevents that from happening because you can only exercise this contract on the October 24 expiration day. But we can still benefit…
VIX options provide terrific clues about where most traders expect the VIX to be on option expiration day.
The current VIX option prices (as of Tuesday) tell us that traders expect the index to move lower over the next week. We know this because the price of VIX put options is significantly more than the price for similar VIX call options.
For example, just compare the VIX October 24, $21 calls to the VIX October 24, $21 puts. The calls closed Monday offered at $1.25, while the puts were offered at $3.70 (I use my trading quote system to track these prices, but you can also find them here).
In other words, even though the VIX calls are $0.30 in-the-money (meaning they have intrinsic value), and the VIX puts are $0.30 out-of-the-money, the put options are trading for nearly three times the price of the call options.
VIX option traders clearly expect the index to move lower in the short term. And a falling VIX (falling volatility) usually accompanies a rising stock market.
Best regards and good trading,
Jeff Clark
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Do you have a go-to stock market “crystal ball?” What are your trading strategies during times of rising volatility?
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