Options Moves Portend a Nightmare in 55 Days

One veteran trader is looking back to the future.
Author:
Publish date:

While New York's TV weathermen pine about record highs, Wall Street may want to take a minute to decipher the signals being sent by the options market.

Statistically, summertime options expiration has marked some very important prepanic inflection points in the stock market.

Just after the market peaked in 1987, the

Dow Jones Industrial Average

began trending downwards, and crashed in October. The crash arrived 55 days following August 1987 options expiration. In 1998, the July options expiration also marked a top again for stocks; then the devaluation of Russia and

Long-Term Capital Management's

failure hit and a mini-correction ensued that was just shy of the 20% normally qualifying as a "bear market cycle."

That evidence, coupled with today's stunning drop in the

Nasdaq 100

index, has some watching closely. Because options have grown in importance as an sentiment indicator,

R.F. Lafferty

options strategist and a perma-bear Jay Shartsis says he's looking for "a few more days like this. And what about a few more months? The worst could be yet to come."

The

Chicago Board Options Exchange's Volatility Index

, or VIX, exploded after receding into a Valium-like complacency of record lows last Friday. The VIX, a barometer of fear in the broader market, spiked up 15.10% Tuesday to 22.41 amid crazed selling among equities this afternoon.

All this could mean something drastic is in the offing. Shartsis says a big drop could be in store on Oct. 1, 55 trading days after last Friday's expiration, when the stock market hit all-time

highs. While this kind of prediction sounds more akin to a street-corner preacher's warnings to repent, Shartsis says history is on his side.

"The crashes in the past didn't come right after the market topped," he says. In 1929 and 1987, the market crashed 55 days after the top. "It was only a few weeks later when people started to panic," Shartsis says.

Among the vulnerable points is the Internet sector. Shartsis points out that even as the Dow and other indices were at new highs, key Net stocks haven't mimicked that action.

TheStreet.com Internet Sector

index, or DOT, never made it back to the highs set in April of this year. "They've lost their juice, and that alone is meaningful," he says.

The looking glass through which most pros peer for clues is the

S&P 100

options, and technical analysts prize price data on so-called mirror-image options -- that is, put and call options 10% or so out-of-the-money (levels that would indicate speculation of a drastic move).

In July, Shartsis says, things were relatively normal. But at the start of the August cycle, the OEX closed at 710 on Tuesday; the August OEX 795 call trades at 3/8 ($37.50), compared with last month's 1/8, a price that presupposes a worthless expiration. The call being priced higher than that 1/8 (or 1/16th) means there's too much optimism in the market. "This bidding up of the calls is bearish," he says.

In October, we'll check back in with Shartsis on his proclamation, based on his theory that goes something like this: "Things can't get any better. They can certainly get a lot worse."