Editor’s Note: In today’s Daily, our colleague Jeff Clark explains how following one of his favorite indicators can make you a better trader.

Today, I’d like to share an idea that can make you a better trader.

It’s the one indicator I follow more than any other when I want to know where the stock market is headed next. It’s a twist on a commonly followed market indicator: the Volatility Index (VIX).

The Volatility Index is a measurement of fear in the marketplace.

A high and rising VIX indicates that investors are scared and traders are bearish.

A low and declining VIX indicates that investors are bullish and traders are complacent.

The VIX is a good contrary indicator, and it does help warn investors when the market is at extreme levels and vulnerable to a reversal. Some traders even refer to the VIX as a “crystal ball for the stock market.”

That’s a bit of an exaggeration. You see, the VIX does flash caution signs when the market gets a little too overheated to the upside or the downside. But the VIX doesn’t tell you how soon those trends are going to reverse. So trying to time a trade by watching the VIX is like driving on a road where the stoplights are timed inconsistently.

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One light might be yellow for five seconds before it turns red. The next light stays yellow for 20 seconds. Then the next light might stay yellow for four minutes. It’s hard to drive on that kind of a road. And it’s hard to trade by just watching the Volatility Index.

But… watching VIX options, on the other hand, well… that’s a better crystal ball.

VIX options are difficult to trade. The half-dozen or so times I tried were all disappointing. It didn’t matter if I got the direction right. It didn’t matter if the VIX moved far beyond my upside or downside targets. It is remarkably difficult to profit trading options on the VIX.

But watching them trade can make it far easier to profit on the rest of the stock market.

Let me explain…

VIX options are European-style contracts—meaning they can only be exercised on option expiration day. This eliminates any possible “arbitrage” effect (the act of buying an option, exercising it immediately, then selling the underlying security for a profit). So VIX options will often trade at a discount to intrinsic value.

For example, last Tuesday, the Volatility Index closed at 10.76. At that level, the VIX May 17 $12 puts are intrinsically worth $1.24. But they were offered at only $0.60. That’s a $0.64 discount to intrinsic value…

If it existed on a regular American-style stock option, you could buy the put, exercise it, and liquidate the position all day long, picking up $64 for every contract you traded. The European-style feature prevents that from happening because you can only exercise this contract on the May 17 expiration day. But we can still benefit…

VIX options provide terrific clues about where most traders expect the Volatility Index to be on option expiration day.

The current VIX option prices tell us even traders who are making bearish bets on the VIX expect the index to move higher in May. This sentiment is even more evident if you compare the VIX May 11 calls to the VIX May 11 puts. The calls closed Tuesday offered at $1.50, while the puts were only $0.15. (I use my trading quote system to track these prices, but you can find them at quotes.freerealtime.com.)

VIX calls are trading for 10 times the price of the equivalent VIX put options.

VIX option traders clearly expect the index to move higher in the short term. And a rising VIX (rising volatility) usually accompanies a falling stock market. So if you’re making short-term bullish bets, be careful as we head into May.

Watch the Volatility Index for signs of investor fear or complacency that can lead to a trend reversal.

But pay closer attention to the VIX options. They’ll improve your timing on reversal trades.

Best regards and good trading,

Jeff Clark
Editor, Delta Report

P.S. If you’d like to receive my free daily market insights, Jeff Clark’s Market Minute, click here and I’ll automatically add you to my list. You’ll also receive a link to my “Guide to Options Trading” just for signing up. This free report will teach you how to trade options the right way… and dramatically boost your overall returns.

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