The bulls are 10 for 10 for the month of July. But, our Crystal Ball says, “not this year.”
The S&P 500 has rallied every July for the past 10 years.
That’s a 100% success rate – with an average gain of 3.5%.
So, with the winds of seasonality blowing so briskly in the bullish direction, we’d have to be nuts to bet against it.
But, that’s exactly what our crystal ball says we should do.
Let me explain…
Regular readers know about the predictive power of VIX option prices. We’ve used extreme deviations in option prices before as a sort of “crystal ball” for the immediate direction of the stock market.
And right now, 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 aren’t 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. (That’s 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 Wednesday, the VIX closed at $16.64. At that level, the VIX July 16 $18 puts were intrinsically worth $1.36.
But they cost only $0.80. That’s a $0.56 discount to their intrinsic value.
If it existed on an American-style stock option, you could buy the put, exercise it, and liquidate the position all day long. You would pick up $56 for every contract you traded.
The European-style feature prevents that from happening. You can only exercise the contract on the July 16 option expiration day.
So VIX options provide strong clues about where most traders expect the VIX to be on option expiration day.
Now, consider this…
On Wednesday, with the VIX trading below $17, the VIX July 16 $17 puts closed at $0.35. Meanwhile, the VIX July 16 $17 calls closed at about $1.60.
VIX calls are nearly five times the price of the equivalent VIX put options. So VIX option traders clearly expect the index to move higher between now and July 16. And a rising VIX (rising volatility) usually accompanies a falling stock market.
The difference is even more extreme if we go out to the end of the month. The VIX July 30 $17 puts traded Wednesday for $0.35 while the equivalent call option was over $3.00.
In other words, traders were willing to pay nine times more to buy VIX calls than VIX puts.
So if you’re making short-term bullish bets – based on stocks always rallying in July – be careful. The crystal ball has an outstanding track record.
And, the crystal ball has turned bearish.
Best regards and good trading,
Jeff Clark
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Source: Jeff Clark Trader
