Covered Call Trading Just Will Not Stop Winning

By Chris Ebert

Option Index Summary

It's been an amazing ride for covered call trading lately. Week after week, these trades have continued to return profits. In fact, 50 out of the past 52 weeks have been winners, and this past week was no exception.

Covered call trading is to the stock market what being a landlord is to the housing market – as long as it's profitable it can be inferred that the market is healthy. The inference this week, at least from the standpoint of covered calls opened 112 days prior to expiration using an at-the-money strike price, is that the stock market remains in good health.

When a trader opens a covered call, it is the equivalent of leasing the underlying stock. That is why covered call trading, or covered call writing as it sometimes called, is also widely known as “share renting”. If the covered calls are opened on a broad-based ETF such as SPDR S&P 500 SPY, the profitability of this so called share renting implies that the stocks that make up the S&P 500 are generally doing O.K.

The Covered Call/Naked Put Index (CCNPI) measures the profitability of share renting. As it has been for every week except two during the past year, the CCNPI showed profitability again this week. That means bullish traders continue to outweigh bearish ones. This bullishness is the reason that recent negative economic developments have not resulted in a major sell-off. Negative news has seemingly rolled off the backs of the bulls. That's not to say that the bulls will continue to endure negative news forever; there is a limit, and that limit is being approached.

The Long Call/Married Put Index (LCMPI) measures the strength of bullish emotions, and it is now showing weakness. The weakness has persisted for several weeks now, and that is an indication that the bulls are reaching their limit. The market truly cannot handle much more bad news without reacting negatively.

To add to concern is the Long Straddle/Strangle Index (LSSI). This measure of option trading is currently at a level that is very near the range at which major breakouts tend to occur. Quite simply, the current market conditions mimic conditions that have proven to be unsustainable in the past for periods of more than a month or so. The LSSI has already been at this level for a month, so each passing week makes a big move in the market more likely to occur sooner rather than later. The market cannot sustain its current range bound status for much longer.

From an option trading perspective, a big change in the market seems very probable now. It might not be tomorrow, it might not be next week. But the options are indicating 2013 will quickly reveal itself to be a much different trading environment than 2012. S&P 1400 and Dow 13,000 will soon become memories.

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) – Nearly DUE FOR A BREAKOUT

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 112-day LSSI exceeded its normal range this past August, just prior to the breakout to higher prices that occurred in early September. In mid-November the LSSI exceeded its normal range again, and was immediately followed by a rally. This week the LSSI stands at -5.7%, which again is nearing 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. The direction of the move can be up or down depending on the news that triggers it, but the magnitude of the move tends to be amplified when the LSSI is at its current level. This does not mean that a big move is a certainty, only that whatever move occurs in the upcoming weeks will be out of proportion to that catalyst that sparked it.

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!”