The crystal ball is warning us not to trust the current stock market rally.

Friday’s big bounce following the non-farm payrolls report pushed the S&P 500 to its highest level since mid-December. It broke above several resistance levels – like the 9-day and 20-day exponential moving averages (EMAs).

And it changed the sentiment of many of the financial television talking heads – who were wildly bearish on Thursday but flipped to bullish following Friday’s move.

Most of the talking heads are now looking for higher stock prices over the next several weeks.

But the crystal ball suggests otherwise…

The Predictive Power of VIX Option Prices

We haven’t looked into the crystal ball since August 15. Back then, the market was putting on a massive rally. But the crystal ball was warning us to be careful. It predicted stocks would be lower in the weeks ahead.

Two weeks later, the S&P 500 was down 9%. Six weeks later, the market had lost 16%.

Regular readers know we’ve used extreme deviations in option prices before to predict the immediate direction of the stock market. The trading signals from VIX options are so reliable, that I refer to this indicator as a “crystal ball.”

And right now, Volatility Index (VIX) call options are much more expensive than the equivalent put options. Whenever this condition exists, the broad stock market is vulnerable to a sharp and sudden decline.

You see, VIX options are not like most stock option contracts, which can be exercised at any time.

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, and then selling the underlying security for a profit).

So, VIX options will often trade at a discount to intrinsic value.

For example, on Friday, the VIX closed near 21. At that level, the VIX January 11 $23 puts were intrinsically worth $2.00. But, they were offered at only $1.60. That’s a $0.40 discount to their intrinsic value.

If this put existed on a regular, American-style stock option, you could buy it, exercise it, and liquidate the position all day long – picking up $40 for every contract you traded.

But the European-style feature prevents that from happening because you can only exercise the contract on the January 11 option expiration day.

A Bearish Short-Term Outlook

Because of its unique pricing structure, VIX options provide terrific clues about where most traders expect the VIX to be on option expiration day.

As I mentioned above, the VIX traded at 21 on Friday. The VIX January 18 $21 call options were offered at $1.65. Meanwhile, the VIX January 18 $21 puts were offered for $0.50.

In other words, traders were willing to pay more than triple the price for a VIX call option than for a VIX put option.

This sentiment is just as evident if you go out a little further and compare the VIX February 15 $21 calls to the VIX February 15 $21 puts. The calls closed Friday were offered at $2.80, while the puts were only $0.90. (I use my trading quote system to track these prices, but you can find them at FreeRealTime.com.)

When VIX calls are far more expensive than the equivalent put options, it shows VIX option traders expect the index to move sharply higher over the next few weeks.

And a rising VIX (rising volatility) usually accompanies a falling stock market.

So, if you’re making short-term bullish bets, be careful. The VIX “crystal ball” has a very good track record… I’m betting it’ll prove correct this time, as well.

Best regards and good trading,

Jeff Clark

Source: Jeff Clark Trader