On Friday, the S&P 500 closed at a new all-time high – above 5000 for the first time ever. Technology stocks led the charge as NVIDIA, Super Micro Computer, Amazon, and Microsoft all posted new all-time highs.
And, speculators were once again jumping over themselves to buy call options and bet on the stock market continuing higher.
But, the stock market’s crystal ball was screaming “BE CAREFUL!”
It has been just over 13 months since we last peered into the crystal ball. Back then, the stock market was rallying. But, the crystal ball was leaning bearish. It predicted stocks would be lower in the short-term.
One week later the S&P 500 was 100 points lower.
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 12.93. At that level, the VIX February 14 $14 puts were intrinsically worth $1.07. But they were offered at only $0.85. That’s a $0.22 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 $22 for every contract you traded. The European-style feature prevents that from happening – because you can only exercise the contract on the February 14 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.
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Heading Down
Now, consider this…
On Friday, with the VIX trading below $13, the VIX March 20, $13 puts – which are $0.07 in the money – closed at about $0.30. Meanwhile, the VIX 20 $13 calls – which are $0.07 out of the money – closed at about $2.00.
(I use my trading quote system to track these prices, but you can find them at FreeRealTime.com.)
VIX calls are nearly seven times the price of the equivalent VIX put options. So, VIX option traders clearly expect the index to move sharply higher between now and March 20. 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 a very good track record. I’m betting it will prove correct this time as well.
Best regards and good trading,
Jeff Clark
Editor, Market Minute