When I want to know where the market is headed next, there's one indicator I follow more than any other...
And today, it's signaling a year-end market rally...
As longtime readers know, there are many ways to gauge the market... like
moving averages,
relative strength indexes,
stochastics, and
momentum indicators. These should be in every trader's toolbox.
But if you forced me to watch just one indicator, I'd look at
Volatility Index ("VIX") option prices.
Let me explain...
When most people
buy or sell stock options, they focus on what the VIX is doing. The VIX is a widely followed indicator that measures the price of options on the broad market. It rises and falls with investor fear levels. We want to buy when the VIX makes an extreme move to the upside (when people are scared). And we want to sell when the VIX makes an extreme move to the downside (when people are complacent).
The VIX is a good contrary indicator, but there are different degrees of fear and complacency. And it's hard to tell by just watching the VIX if we're nearing the beginning or the end of a fearful or complacent move.
When the market gets jumpy – when the Dow Jones Industrial Average moves 300 points lower one day, and then jumps 300 points higher the next – many technical indicators conflict with each other. Some indicators get overbought. Some get oversold. This makes it difficult for traders to get a clear picture of what to expect from the market over the next few months.
VIX option prices clear up that picture.
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.
For example, back in July I told you that
VIX options were warning of falling stock prices through October. VIX call options were seven times more expensive than the put options. Traders were betting on a rising VIX. And since increased volatility usually comes with falling stock prices, the VIX options were predicting a market decline.
The VIX options were right.
Today, though, the picture is different. The VIX closed Friday at 22. The VIX December 22 calls are trading for $2.15, while the December 22 puts are $4.30. So options traders are willing to pay 100% more to bet on the VIX moving lower than on it moving higher by the December expiration day.
VIX option traders clearly expect volatility to move lower over the next few months. And falling volatility usually translates into rising stock prices...
With the market now trading about 7% off of its highs, any additional weakness this week will give traders a great opportunity to take advantage of a year-end rally.