...and speakin' of contrarians... is this article of any value?? this guy says the market is ready to explode... he thinks it might be to the upside but maybe to the downside. hmmmm...
biz.yahoo.com
Wednesday July 12, 3:01 pm Eastern Time
worldlyinvestor.com Sector of the Day
Trader Complacency May Mean a Market Move's In Store
By Lawrence G. McMillan, Columnist
The CBOE Volatility Index is on the low end right now. Here's what that means for stocks.
Forget about Tarot cards and stop trying to read between Alan Greenspan's lines. There are more useful ways to predict how the stock market will move.
For traders, the Chicago Board Options Exchange Volatility Index (Nasdaq:$VIX) has been a stalwart signal since it was introduced in the early 1990's.
The index measures the speed of price movement on the S&P 100 Index (Nasdaq:$OEX). For those not familiar with it, the S&P 100 is a broad market index, composed of the largest stocks whose options trade on the CBOE. It mirrors the S&P 500 Index (Nasdaq:$SPX) rather closely, although $OEX trades at about one-half the price of $SPX.
The volatility mainly tells traders the average premium levels of the $OEX options traded - and much like stocks, it can change very quickly.
For many years, the $OEX options have been heavily traded by speculators trying to capitalize on broad market moves. Looking at the index right now tells me that the market may be positioning to make a strong move to the positive. Here's how I know that.
Reading Between the Lines
It is fairly typical that, when the market goes into one of its free-falls, option prices shoot through the roof. Since there is a direct relationship between implied volatility and option prices, $VIX rises dramatically when the market falls quickly. In this bearish scenario, traders pay up for options - particularly put options. That's because traders are betting on a continued drop in the market by purchasing puts and selling calls.
On the other hand, if everyone is complacent and the market is rising steadily, then $VIX drops to low levels, indicating that implied volatility is low. In this rising market scenario, most traders are happy and no one is interested in paying high prices for options.
The volatility index is useful mostly as a contrarian indicator, for it shows when the public is overcome with fear and panic (when $VIX is trading at extremely high levels) or when the public is too complacent (when $VIX is trading at extremely low levels).
So How Do You Play?
Traders who are contrarians - and that includes me - find $VIX a useful guide, for we know to expect just the opposite of what the masses are doing. That is, when $VIX has spiked up to dramatic heights during a bearish phase, it is normally time to start thinking about buying the market - just when everyone else is panicking.
Similarly, when everyone else is complacent and $VIX is at very low levels, it is time for the contrarian to be on his toes. It doesn't necessarily mean that the market will fall when $VIX is at extremely low levels, but it does mean that it's about to explode - there will be a major move in one direction or the other.
In 1995, for example, the market rose dramatically after the lowest $VIX readings in history. Most of the time, though, a low $VIX reading precedes a market peak (at least, a short-term peak).
On the Low End
So, where do we stand right now? We're near the lower extreme. The index has declined quite a bit lately (see chart), and in fact it has done the same thing in each of the past two Julys. As you know, both July 1998 and July 1999 marked peaks for the market.
Is the same scenario unfolding again? It well could be, for the recent rally has pushed some of our indicators into overbought territory - and any weakness from here will probably generate sell signals. Still, I would not recommend buying $OEX puts (or other broad market index puts) until some of the support levels are broken. That would be 775 on $OEX or 1435 on $SPX.
As long as the indexes remain above those levels, enjoy the ride on the upside. But be alert, for $VIX is fair warning that there is a lot of complacency on the part of option traders right now, and that complacency is usually followed by a very explosive market. If the explosion occurs on the upside, well and good for most traders, but if it's going to be on the downside, defensive action must be taken when support levels are broken.
Note: Recently, $OEX has lost some of its liquidity, but other measures -- such as the implied volatility of options on the Nasdaq 100 tracking stock (Amex:QQQ - news) -- show similar patterns. Option traders are becoming complacent so be alert.
Lawrence G. McMillan is author of the best-selling book, Options As A Strategic Investment. He is President of McMillan Analysis Corp., trades for his account and others, and he publishes several market newsletters, including The Option Strategist. This report does not specifically recommend a trade unless support levels are broken. He does not have positions in the securities mentioned in this article at the time of publication. But he will be buying $OEX puts if support levels are broken as the article suggests.
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