Traders, as an option mentor I am constantly asked by my option mentoring students where I think the market is heading. Rarely do I have an answer, because I think a coin flip would be far better than me over time at picking which direction the market will be moving toward. However, I may have to stick a leg out and call this a top. This is not because of technical analysis of a stock, which I am convinced is about as valuable as pyrite. It’s what the volatilities are doing.
All over the web traders that I know and hold in high esteem are talking about the VIX Contango. Rather than explain Contango Ill refer you guys to my friend and resident VIX expert Bill Luby of VixandMore. Instead I will point toward what I will point out how regular traders can see Contango rearing its ugly head. It’s actually quite simple; the time spread and the tendency of IV to be mean reverting.
Time Spreads:
Traders, keep an eye on how the front two months in the SPX. Currently, those months are October and November. Yes, September is still trading, but at this point SEP options have so little vega, and so much gamma that the IV's are not a reliable number to follow. As I have stated in the past, when the front month falls more than two points below the back month, the market is almost certain to turn around. This is Contango in a real trading environment (in fact this is what creates the Contango in the first place). As of late, when we have seen the front month have a higher implied volatility than the rear that has generally be a great sign for a market bottom (although there have been a few exceptions). But, since the melt down, when the front month has been more than a point over the back month, the SPX has rallied quickly in the short term.
Currently the OCT is trading a discount of just under 2 full percentage points under November. In a case like this I would almost exclusively sell November and buy October. This is tough on retail traders because of the margin. The only thing a trader does not want to do is BUY a calendar. I know the IV's seem low but gamma and subsequent increase in October IV will KILL this trade.
Mean reverting volatility:
One of my arguments for thinking we may sell off is that IV and the market have been oscillating for the past 3 months (since the flash crash). The market has been reaching lower lows and higher highs in both the VIX and the SPX. This is a trader’s misery and can be one of the toughest environments to trade in. A trader must be opportunistic. Looking at a chart of the VIX, with the weekend coming out today and tomorrow If the market behaves tomorrow I would expect the VIX to break down to new lows since the flash crash (net of weekend decay). With Rosh Hashanah ending, and a whole host of new next week, I would find it hard to believe that the VIX will stay that low.
In order for this to happen, the SPX, which also seems to be topping out, currently about 15 points lower than the last time it broke 1100 is likely to drop. As in the time spread issue I pointed at earlier and I think we could see a VIX back at 26-27, with the SPX trading down to 1020. At the point I will likely be making the opposite call I am making here.
What about Retail Traders?
Traders that like income trading in this environment I would strongly suggest the same thing I am telling my option mentoring students, I think it is important to insure any butterfly, it is okay to wait to trade a condor and for the love of all that is good, please, stay away from the time spread.
Do not forget to sign up for the AM Pit Report. Currently I am managing a small DIA butterfly.
