Why Options Traders See a 10% Market Correction

The Teflon market began chipping on April 7 after another earthquake hit Japan, threatening to bring a second tsunami.

The tsunami alert was a false alarm, but the S&P held a 4-day losing streak till Wednesday. Try as investors may, however, they haven't been able stay away from stocks. With all that easy money flying around and few other options for high returns, equities have held their year-to-date gains despite mounting geopolitical troubles that threaten to derail the recovery.

But a big trade Thursday in the SPDR S&P 500 ETF shows stock investors' nerves of steel are faltering. The trade, called a put fly, positioned for a gain if the S&P 500 breaks through the key 1304 technical level and plunges 10% from there to 1180 (a 118 level on the SPY).

"To me it seems interesting that people are concerned with downside more than they were," said Jim Iuorio, Director at TJM Institutional Services. "There are a lot of dark clouds gathering, oil, labor numbers, there are more nerves," he added.

The put fly turned out to to be a bad trade for Thursday because the S&P broke through the 1304 level and rejected it, ending higher. That was a moderately positive signal for the index, Iuorio noted, but the trade belies the persistently low volatility index, which is holding below 17 despite investors' growing skittishness.

Iuorio expects volatility to shoot higher once Fed liquidity dries up, so he says it's prudent to buy it now that it's cheap.

"If you keep preventing a correction through government liquidity, when that correction finally comes it, it could be more dramatic than normal," the Options Action contributor said.

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