Friday, March 8th 2019
Trouble Ahead for the Market? Signals from the Options Market Say So
Contango when implied volatility is low in the short term and higher in the long term maturities is an important technical indicator options signal for the market direction.
The options market is showing warning signs for the market, with short term contango flipping to backwardation, indicating a potential downturn. ORATS offers a signaling service for subscribers to track these indicators.
Warning signs from the options market started Monday when the ORATS early warning service alerted subscribers of the beginnings of trouble for the market.
By near the close Wednesday, when we take our final snapshot of the market 14 minutes before the close, things had deteriorated.
One of the signals we track is short term contango. Contango is the relationship where the shorter term maturities have lower implied volatilities than the longer term ones. This is the normal state of affairs for the options market happening 72.5% of the days since 2007.
Sometimes, when contango flips to backwardation (you guessed it, when the short term IVs are greater than the long term), it is usually already bad or going to get bad for the market.
As in the graph from 2017 on, the red circles show falling contango (rising backwardation) and falling markets.
ORATS has a other interesting signals, like our forward volatility signal. Unfortunately for the bulls, that turned negative recently too.
If you want to subscribe to our signaling service, contact us here.
Options pricing models produce theoretical values for options and implied volatilities. Here we show common methods for calculating IV and how to interpret them.
Implied volatility, contango, and forward volatility can be used to predict underlying movement. Ex-earnings IV for stocks is explained. Backwardation is described as is the flat volatility method.