My perfect crystal ball

While we always say there is no crystal ball in the market, we often try to get one via various market indicators. I have followed many and each of them provides some unique perspective to give me a hint where the market may go near term or longer term. Certainly there is no certainty, especially based any single indicator. But there is one indicator which is nearly as clear as a crystal ball based on my experience. When it flashes violently, we need to get its attention if you don’t want to lose money. I’m talking about VIX, the measurement of fear in the marketplace as we all know.

“Oh, what a big deal!” I’m hearing this grumbles from most of you probably. Ok, let me explain a bit more here.

Indeed there is no secret that VIX is fluctuating daily and quickly depending on the sentiment of the market at any moment. Generally it tends to inversely correlated with the market, i.e. when VIX is moving higher suggesting investors are scared and bearish, stock markets tend to move lower. Vice versa, VIX is lower when investors are bullish and complacent, the markets are often higher. So where is the crystal ball with VIX when it moves so fast and can change the direction minute by minute？ No, there is no way to simply watch VIX and trade accordingly on a daily basis. It is nothing different from driving car in a road with the traffic lights that keep changing without a regular frequency and consistency. You can drive yourself into crazy if on such a road.

But watching VIX options, on the other hand, is telling you a very different story and actually it can be really as clear as a crystal ball! Here it needs a little bit education how the VIX option is regulated. Even if you know a bit about options, most of you are probably only familiar with the American’s style options, where you could buy a call or put option, exercise it, and liquidate the position all day long if you’d really like, although most option traders won’t do that but it is allowed per the regulations here. However, VIX options are European-style contracts, which are set up in such a way that they can only be exercised on option expiration day. What it means is that traders cannot take the possible “arbitrage” effect when one can buy an option, exercise it immediately, then sell the underlying security for a profit, if there is a discount to intrinsic value. Now think about it, if a trader has to wait till the expiration day to exercise, which could be days, weeks later or even longer, would they just buy options as freely and easily as for the US-style options? Obviously not as they don’t want to pay too much for something that may lose value quickly over time, right? In other words, with the EU-style options, traders will generally only bet with their money for something they truly believe is coming. And they are usually doing a pretty darn good job in predicting where VIX may be going in the next few days or weeks. This is especially true when there is a sharp difference between calls vs puts for the same VIX strike price, which often suggests VIX may likely be on the verge of either shooting higher or plunging lower. So watching how the VIX is priced in options can really serve as your crystal ball. The extreme condition is of course not coming often but when it comes, you better pay attention to it.

If you care what I’m telling you, then listen carefully: we are now at such a moment that VIX calls are priced in many times more than puts, meaning traders are vigorously buying calls than puts expecting a jump of VIX in the days and weeks ahead. We all know, when VIX jumps, the markets may likely drop. You may recall I told you last week that I expected a higher VIX this week. Although I got the hint from other TA indicators, the VIX call option was giving me a more crystal ball direction. When the VIX closed at 13.28 last Friday, its call options at the money for July 17 were 3 times more expensive than the same strike puts. So I knew we would likely see a hike of VIX in the coming week. Sure we got about a 10% jump on Monday just one trading day later. Since VIX is very volatile and can easily drop as well, I took my one day nice profit by closing the long VIX trade for that moment. But if you think the worst is over and bet for a higher market in the weeks ahead, be careful! As I said, my VIX crystal ball is still largely skewed towards a much higher VIX deep into August! Let’s using today’s (Friday) call/put prices for VIX as an example. Today VIX closed at 12.38. Yes, lower than last Fri with apparent FOMO ongoing. Using the closest at the money strike (12.0) to check its call/put prices for next week, you see a 10 times more expensive for call than put, i.e. traders are willing to buy 10 times more expensive call options for VIX to bet VIX will jump next week. We are talking about just in days, which is very telling. Now if we go further to another month into Aug, it is even more astonishing, something like 20 times more expensive for calls than puts. There is no way savvy VIX traders are joking with their money. I’m happy to see another great opportunity presented in front of my eyes and I did have been long VIX aggressively now.  

As I often said, you don’t need to believe me as I can always be wrong for my calls. But what I can tell you is that my VIX crystal ball is nearly a perfect “fortune teller” for me. When it flashes violently, I always listen to it religiously and then trade accordingly. By the way, following Monday’s large selloff, I did temporarily switch to the long side as I saw a bullish move coming. As I told my group, I was long AMZN, BA and INTC for the week and it turns out to be a great short term speculation. But I’m net short now for next week or so until the market tells me otherwise.