It’s Time to Be Cautious on Stocks Right Now

The market’s crystal ball is giving us a warning sign.

In 2009, I first wrote about using the price action in Volatility Index (“VIX”) options as a way to tell where the stock market is headed. I said watching VIX options was like staring into a crystal ball for the market.

Longtime Growth Stock Wire readers know the VIX is Wall Street’s fear gauge and an excellent contrary indicator.

We want to buy when the VIX makes an extreme move to the upside (when people are scared).

[ad#Google Adsense 336×280-IA]We want to sell when the VIX makes an extreme move to the downside (when people are complacent).

The VIX helps warn investors when the market is at extreme levels.

But when the market isn’t at extreme levels (like today), the best clues for where the market is headed come from VIX options.

And today, they’re telling us to be cautious on stocks over the next few months…

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 Friday, 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. 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 by trading options on the VIX.

But we can still benefit from VIX options. You see, they provide terrific clues about where most traders expect the VIX to be on option-expiration day.

The current VIX option prices tell us that traders expect the 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.

Best regards and good trading,

Jeff Clark

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Source: Growth Stock Wire