Tuesday, December 22, 2009
Yesterday, I showed you how to use Bollinger Bands to make quick, short-term trades and time your option bets. Today, I've got something a little different...
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. But it's not of much use when stocks are range-bound, as they are now and have been for the past few weeks. Instead, the best clues now come from VIX options.
VIX options are difficult to trade. The half-dozen or so times I tried were all disappointing. It didn't matter if I got the direction right. It didn't matter if the VIX moved far beyond my upside or downside targets. It is remarkably difficult to profit trading options on the VIX.
But watching them trade can make it far easier to profit on the rest of the stock market. Let me explain...
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 Wednesday, December 17, the Volatility Index closed near 21.50. At that level, the VIX January 30 puts are intrinsically worth $8.50. But they were offered at only $6. That's a $2.50 discount to 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 $250 for every contract you traded. The European-style feature prevents that from happening – because you can only exercise this contract on January's expiration day. But we can still benefit...
VIX options provide terrific clues about where most traders expect the Volatility Index to be on option-expiration day.
The current VIX option prices tell us even traders who are making bearish bets on the VIX expect the index to move higher into January. This sentiment is even more evident if you compare the VIX January 22.50 calls to the VIX January 22.50 puts. The calls closed last week offered at $3.90, while the puts were only $1.00. (I use my trading quote system to track these prices, but you can find them at quotes.freerealtime.com.)
VIX option traders clearly expect the index to move higher in January. And a rising VIX (rising volatility) usually accompanies a falling stock market. So if you're making short-term bullish bets, be careful as we head into the New Year.
Best regards and good trading,