The S&P 500 has gained 300 points since the CBOE Volatility Index (VIX) generated a buy signal back on September 9.

We wrote about it here. And we admitted that it seemed odd to expect stocks to rally during what’s known to be “the worst month of the year” for the stock market.

The S&P 500 loses an average of about 2% during the month of September. Many of the financial television talking heads were expecting a stock market correction this month. 

And it sure looked like they were right when the index started September by losing 4% during the first few trading days.

But then we got the VIX buy signal. So we asked the question, “What if we rally instead?”

We suggested that if the VIX buy signal played out as the other buy signals did this year, we could be looking at new all-time highs within about three weeks.

It only took two weeks.

Now here we are, approaching the end of “the worst month of the year.”

The stock market is at its highest level ever. The S&P 500 recovered its early September losses and turned positive. It’s up 1.4% for the month.

It seems as though no one is talking about the possibility of a correction anymore. Most of the financial television talking heads are now looking for a fourth-quarter rally to finish out the year.

What if we fall instead?

After all, that’s what VIX option prices are suggesting could happen over the next few weeks.

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, 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 aren’t 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. (That’s 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 Wednesday, the VIX closed at $15.41. At that level, the VIX October 2 $16 puts were intrinsically worth $0.59.

But they cost only $0.36. That’s a $0.23 discount to their intrinsic value.

If it existed on an American-style stock option, you could buy the put, exercise it, and liquidate the position all day long. You would pick up $23 for every contract you traded.

The European-style feature prevents that from happening. You can only exercise the contract on the October 2 option expiration day.

So VIX options provide strong clues about where most traders expect the VIX to be on option expiration day.

Now, consider this…

On Wednesday, with the VIX trading below $15.50, the VIX October 16 $16 puts closed at $0.17. Meanwhile, the VIX October 16 $16 calls closed at about $2.40.

VIX calls are 14 times the price of the equivalent VIX put options. So VIX option traders clearly expect the index to move sharply higher between now and October 16. 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