Tuesday, November 2, 2010
Volatility Index (VIX) options are once again providing clues as to the stock market's most likely direction... down.
It's been about 10 months since I first wrote about using the premium on VIX options as a crystal ball for the stock market. Since then, the crystal ball has been dark. Other than right before the flash crash, VIX option traders have been clueless – showing no real bias, bullish or bearish, all year.
But that's changing now.
Remember, 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 couple of weeks. Instead, the best clues come from VIX options.
VIX call options for December expiration are now four times more expensive than the equivalent put options. For example, the Volatility Index closed last Friday just over 21. The VIX December 21 call options closed at $4.20, while the VIX December 21 puts were just $0.90.
Traders are clearly betting on an increase in volatility as we head into December. And an increase in volatility usually translates into a decline for stock prices.
The November option series, however, doesn't look quite so ominous. The VIX November 21 calls were priced at $1.65, while the November 21 puts were $1.20.
There's a slight bias toward a higher VIX heading into November expiration, two weeks from this Friday. But the difference in the call and put option premiums is relatively insignificant.
Many of my short-term trading indicators are warning of an impending stock market decline. But the VIX option premiums suggest we may be in for a couple weeks of sloppy, back and forth trading – similar to what we've seen over the past several sessions.
The real downside fireworks should light up around Thanksgiving.
Best regards and good trading,
The last time Jeff's "crystal ball" glowed was about a year ago, when it showed him an imminent flash crash. Read Jeff's last prophetic warning here: A Crystal Ball for Trading Pros.
For a clear description of what VIX options are, and what they indicate for the stock market, don't miss Jeff's recent essay here: You Won't Hear This on CNBC.
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