The options market often reveals the truth about the market….not talking heads.
Many self-directed investors turn to the major financial media outlets…Bloomberg, CNBC, etc. when, in fact the options market offers the most accurate picture of market expectations.
Over the past two weeks options traders have priced in higher volatility, as the VIX (^VIX) has climbed over 25% while the S&P 500 has moved sideways.
This same scenario has occurred before…right before the 1987 crash.
In mid-July 1987, the major market benchmark was making new highs while the VIX was pushing to new lows. This is typically how it works. The market goes up and the VIX goes down because there is less fear in the market during rallies.
But by mid-August the VIX began to push higher while the S&P continued to make new highs. Options traders and investors alike had become fearful of a sharp decline as the market seemed toppy at the time.
The VIX shot up almost 40% and soon after the market started to collapse until the eventual Black Monday crash occurred.
But is this enough evidence to hit the panic button? Of course not.
This same type of scenario has happened 13 other times. And the other occurrences were not nearly as catastrophic. Nine out of the thirteen showed positive returns over the next six months while the remaining four showed an average decline of -2.7%.
If you actually look at the options market going 6 months out the chance of a normal 10% correction occurring is only 24%… basically, a one in four chance. Over 20%… less than a 10% chance.
Yes, a crash could occur, but I am not going to make investment decisions based on anomalies. I am not going to liquidate my account based on someone’s opinion of a potential market crash. I turn to the options market for realistic probabilities and use strategies based on my assumptions.
I do agree that the market looks a bit toppy at the moment, but I am not going to liquidate my account as a result. I am going to use a strategy that takes advantage of a potential decline…something like a bear call spread in the SPY.
Editor and Chief Options Strategist