The market’s crystal ball is giving us a warning sign. Watching the price action in Volatility Index (VIX) options is like staring into a crystal ball for the stock market.
The Volatility Index is a measurement of fear in the marketplace. When the VIX is high and rising, investors are scared and traders are bearish. A low and declining VIX indicates strong bullish sentiment and complacency among traders.
The VIX is a good contrary indicator, and it does help warn investors when the market is at extreme levels. Today the VIX is a historically low levels. Some of the best forward looking clues about future stock market performance come from VIX options.
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 their intrinsic value.
For example, on July 11, the Volatility Index closed at 12.08. But the VIX July 14 puts – which are intrinsically worth $1.92 – were trading at only $1.60. That’s a $0.32 discount to intrinsic value…
If it were a regular American-style stock option, you could buy the put, exercise it, and liquidate the position, picking up $32 for every contract you traded. The European-style feature prevents that from happening – because you can only exercise this contract on July’s expiration day.
This makes VIX options difficult to trade. It is remarkably difficult to profit by trading options on the VIX.
But we can still benefit from VIX options… they provide clues about where traders expect the VIX to be on option-expiration day.
The current VIX option prices tell us that traders expect the VIX index to move higher in the months ahead. The VIX July 12 calls closed last week at $0.75, while the July 12 puts were only $0.19. In other words, option traders were willing to pay three times more to bet on the VIX moving higher than on it moving lower.
The difference is even more significant going out to October. The VIX October 12 calls are trading for $3, while the October 12 puts are just $0.40. So options traders are willing to pay seven times more to bet on the VIX moving higher than on it moving lower by the October expiration day.
VIX option traders clearly expect volatility to move higher over the next few months. And rising volatility usually translates into falling stock prices. With the market trading at all-time highs, it’s time to be cautious on stocks right now.