Thursday, August 20, 2015
Volatility is ready to explode.
The Volatility Index (the "VIX") – Wall Street's fear gauge – closed Tuesday at less than 14. That's at the lower end of its 2015 trading range between 12 and 21.
So despite the choppiness of our stock market, the troubles in China, Japan, Greece, and elsewhere, and worries over what will happen if the Fed raises interest rates in September, investors are still relatively fearless.
For now, anyway.
As I'll explain below, fear is about to come back into the market in a big way...
Take a look at this chart of the VIX along with its Bollinger Bands...
The Bollinger Bands – which measure the most likely trading range for a stock or index – are contracting. The bottom graph displays the Bollinger Band width, which is now about as narrow as it has been in the past year.
We've seen before how a low VIX and tight Bollinger Bands often set the stage for a big increase in volatility. And a big jump in volatility usually comes with a big move lower in the stock market.
When this situation developed in September and December last year, the S&P 500 dropped 6% and 5%, respectively.
The VIX option prices are also favoring an increase in volatility.
Regular readers are familiar with VIX options. VIX options are European-style contracts – meaning they can only be exercised on option-expiration day. And they provide terrific clues about where most traders expect the VIX to be in the future.
At Tuesday's close, the VIX was at 13.79. The VIX September $14 calls – which expire in one month – were trading at $2.00. But the VIX September $14 puts – which have $0.21 of intrinsic value and should be more expensive than the calls – closed at just $0.50. So option traders are willing to pay four times more to bet on the VIX moving higher than on it moving lower.
The price discrepancy for the October series of VIX options is even more extreme. The VIX October $14 calls are at $2.80, while the October $14 puts are at just $0.60.
This isn't as large a difference as we saw a few weeks ago when the VIX was at 12 and the calls were more than 40 times the price of the puts. But the S&P 500 is 20 points lower now.
Based on the current price discrepancy in the VIX – and the narrowing of the VIX Bollinger Bands – it looks like we're due for a big increase in fear.
And increased fear usually comes with a lower stock market.
Best regards and good trading,
"Lots of investors have an important question on their minds right now," Brian Hunt and Ben Morris write. "Should I be worried about a crash?'" They say the answer is YES... if that's what it takes for you to put a catastrophe-prevention plan in place. Get all the details here.
The Volatility Index is one of the most widely followed financial gauges in the world. It's also widely misunderstood. Earlier this year, Brian and Ben detailed the three things to know about volatility today. If you know these ideas, "you're ahead of 99.9% of your fellow investors." Learn more here.
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