Last Week's Rally No Surprise To Option Indices

By Chris Ebert

Option Index Summary

The Long Straddle/Strangle Index (LSSI) strikes again!

Last week, the Option Index Update indicated that traders should “Be prepared for something big, soon!” This conclusion was not based upon the fundamentals of companies or predictions regarding upcoming economic news, but rather it was based upon the performance of specific type of stock option trade – the long straddle or strangle.

The Dow was up over 300 points this past week. But why such a big move? In hindsight it might appear obvious that U.S. deal to postpone the “fiscal cliff” was the reason. However, that news was merely the catalyst that got the market moving. The market was already primed for a big move, so when the fiscal cliff news was finally released it really had no alternative but to make that move. It was the emotions of traders, as revealed by the past performance of long straddle option trades, that made the move possible. But emotions themselves cannot normally force the market to do something without a catalyst. The fiscal cliff news provided the catalyst, and the pent-up emotions of traders were then released in the form of big gains.

Using the performance of option trades to analyze future performance of the market may seem a bit like using the speedometer on a car in order to navigate through traffic. As unwise as that might initially appear, it does occasionally have its merits. Anyone who has ever been caught in a traffic jam knows that the longer the traffic remains at a standstill, the greater the chances that it will soon start moving; a commuter's bad luck eventually must run out. Conversely, traffic moving at the speed-limit on a habitually congested highway is often a harbinger of an upcoming slowdown.; a commuter's good luck cannot last forever either.

The Long Straddle/Strangle Index (LSSI) is a sort of measure of congestion. When the index is abnormally high, it signals that the market has been moving quickly for an unusually long period of time. Just as with roadway traffic, the lack of congestion does not necessarily indicate that a traffic jam is imminent, just that as time goes by without congestion the chance of approaching a construction zone or a 5-car pileup increases.

When the LSSI is abnormally low, as it has been in recent weeks, it signals that a traffic jam has gone on much longer than should be expected. The market is basically at the same point it was several months ago – stock traffic is at a standstill. The longer this congestion persists, the greater the chances that the obstacle causing the congestion will be cleared. Just as clearing a roadway of crumpled cars often leads to the immediate movement of traffic, economic news can act as a catalyst to clear the way for impatient traders to finally make their move. The removal of the fiscal cliff obstacle has cleared the way, at least temporarily, for the market to make some moves.

The Covered Call/Naked Put Index (CCNPI) remains bullish this week, and that is a good sign. As long as covered call trading remains profitable, the market is generally healthy. However the Long Call/Married Put Index (LCMPI) continues to show that bullish emotions are weak. Since the Long Straddle/Strangle Index (LSSI) returned to normal this past week, there is no longer a reason to suspect any large price movements are likely unless some truly unexpected economic news develops. Together, the three option indices suggest: “Be prepared for a sideways or choppy market next week, as last week's gains get digested!”

Option Index Definitions

The intent of each option index is to provide a snapshot of the emotions of traders. It is these emotions that drive the markets over the long term, not the news; the news is merely a catalyst that feeds into market emotions that were already present.

• The performance of Covered Calls and Naked Puts reveals whether traders feel bullish or bearish.
• The performance of Long Calls and Married Puts reveals whether traders feel a bull market is strong or weak.
• The performance of Long Straddles and Strangles reveals whether traders feel the market is normal, has come too far and needs to correct, or has not moved far enough and needs to break out of its current range.

Covered Call/Naked Put Index (CCNPI) – Continued BULLISH

Because sellers of at-the-money covered calls or naked puts receive a premium from the buyer, either

of those trades will result in a profit as long as the underlying price does not fall by a greater amount than the premium received. Generally, when covered calls or naked puts are profitable trades, it is an indication of a bull market. Likewise, when there is a bull market, it is often profitable to sell covered calls or naked puts.

An analysis of the performance of covered calls or naked puts opened a moderately long time prior to expiration (such as 112 days) can be useful:

• In a downtrend – Implied volatility is usually higher than usual and the premiums received on these trades are also higher. It is therefore possible for covered calls or naked puts to become profitable when prices are still falling, but no longer falling quickly enough to outpace the faster time decay of the unusually high premiums. Thus a positive 112-day CCNPI in a downtrend is often a bullish signal that marks the end of a downtrend, while a negative CCNPI generally signals that the downtrend will continue.
• In an uptrend – Implied volatility is generally low and the premiums received are lower as well. Covered calls and naked puts become much more sensitive to corrections in an uptrend, because there is a smaller premium to offset any decline in the underlying stock price. Thus a negative 112-day CCNPI often indicates the market has experienced more of a correction than would be expected in a healthy bull market. A negative 112-day CCNPI in an uptrend is a bearish signal that may mark the end of an uptrend, while a positive CCNPI generally signals that the uptrend will continue.

The 112-day CCNPI has been positive since mid-July and remained positive this week, and therefore is an indication of bullish emotions among traders.  Traders “want” to be bullish now, but they need strength to actually act bullish. Determining the strength of these bullish emotions requires a study of the Long Call/Married Put Index (LCMPI).

Long Call/Married Put Index (LCMPI) – Continued WEAKNESS

Because buyers of at-the-money long calls or married puts must pay a premium, these trades will only result in profits when the uptrend occurs quickly enough to offset the loss of value due to time decay. When long calls or married puts are profitable trades, it is an indication of a strong bull market. Likewise, only when there is a strong bull market is it profitable to buy calls or married puts.

An analysis of the performance of long calls or married puts opened a moderately long time prior to expiration (such as 112 days) can be useful:

• At the beginning of an uptrend – Implied volatility usually remains elevated for some time after the previous downtrend has ended, causing the premiums paid to open long calls or married puts to be higher than usual. Long calls and married puts only become profitable when the market has gained sufficient strength to overcome the inflated premiums. Thus, when a previously negative 112-day LCMPI turns positive, it often signals that a bull market has gained strength.
• When an uptrend is well underway – Implied volatility is generally low, and the premiums paid are much lower. Long calls and married puts only become unprofitable when the market has weakened so much that it cannot overcome the relatively low premiums. Thus, a when a previously positive 112-day LCMPI turns negative in an uptrend, it often signals that a bull market is weakening.

The 112-day LCMPI has been negative for several weeks now, indicating that bullish emotions are likely to be weak. Weakness is sometimes temporary, however weakness that lasts for more than a few weeks often leads to a bear market. Long periods of weakness tend to limit rallies as traders become more inclined to “sell on strength”, while also amplifying sell-offs as low-confidence bulls get “stopped out”. Determining whether the bullish emotions, as shown by the CCNPI, and weakness of those emotions, as shown by the LCMPI, are justified requires a study of the Long Straddle/Strangle Index (LSSI).

Long Straddle/Strangle Index (LSSI) –  Returned to NORMAL

Because buyers of straddles or strangles must pay two premiums, one for the call option and another for the put option, these trades will only result in a profit when the market moves up or down very strongly, so that the gains exceed the combined premiums. When a long straddle or strangle returns a substantial profit it is an indication that traders were taken by surprise – they were complacent and those emotions were later proven to be unjustified when the market moved much more than they had expected.  Likewise, when the market is complacent, it can be profitable to buy a straddle or strangle.

When a long straddle or strangle results in a substantial loss, it is also an indication that traders were taken by surprise – they were overly-fearful and those fears were subsequently proven to be unjustified by the market's failure to move.

An analysis of the performance of long straddles or strangles opened a moderately long time prior to expiration (such as 112 days) can be useful:

• In any trend, up or down – The relatively high premium on these trades tends to make them rarely return a profit greater than 4%.  Thus, a 112-day LSSI that exceeds 4% often signals that the market has come too far, too fast and may need a correction to satisfy those traders who were previously complacent and subsequently surprised by the move.
• In a range-bound market – The relatively high premium on these trades tends to result in losses, but those losses seldom exceed 6%. A 112-day LSSI that is negative by a greater magnitude than 6% is an indication not only that many traders were previously fearing a sell-off, causing an increase in option premiums, but that such a sell-off did not materialize. Thus a 112-day LSSI lower than -6% often precedes a breakout, either to a lower price range that confirms trader's prior fears, or to a higher price range that completely puts those fears to rest.

The LSSI stood at -7.7% last week, which is well beyond the maximum range of -6% that is considered normal. Often when the LSSI reaches these levels, the market makes some big moves in the following weeks. After the rally this past week, the LSSI has now returned to normal. This is not necessarily an indication that the rally is over, just that the market has satisfied many traders who were becoming impatient. Traders are now more likely to react to future news by moving prices at a magnitude that would be expected depending on the gravity of that news, rather than cause a knee-jerk move as was seen this past week.

Option position returns are extrapolated from historical data that, while reliable, cannot be guaranteed accurate. It is not possible to match the exact performances shown, because the strike prices and expiration dates used in the calculations will not always be available in actual trading. All data is relative to the S&P 500 index.

The preceding is a post by Christopher Ebert, who uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. He studies options daily, trades options almost exclusively, and enjoys sharing his experiences. He recently co-published the book “Show Me Your Options!”

Related Options Posts:

Fiscal Cliff No Match For Covered Call Trading

Covered Call Trading Just Will Not Stop Winning

To Gauge Future Volatility – Try The LSSI Index