Covered Call Trading Starts 2013 With A Bang

By Chris Ebert

Option Index Summary

Last week's Option Index Update concluded: “Be prepared for a sideways or choppy market next week, as last week's gains get digested!”

Not much has changed since last week's update. Covered call trading continued its nearly uninterrupted streak of profits; a streak that has now gone on week after week for over 13 months. When covered call trading is profitable, the market is healthy and traders tend to be bullish.

Bullish traders are not zombies – they don't just push prices higher and higher without regard for obstacles. But, the general tendency is always to the upside when bullishness prevails, as it does again this week. That is revealed in this week's Covered Call/Naked Put Index (CCNPI) which, not surprisingly, remained positive. The index tends to be positive whenever the bulls retain control.

Bullish traders are not all created equal – there are times that the bulls are so strong that they do appear zombie-like, ignoring bad economic news while soaking up every bit of good news. There are also times when the bulls are weak, as they are this week, which is revealed in the Long Call/Married Put Index (LCMPI). Weak bulls are fickle. They can produce surprising rallies, but the slightest worry over earnings reports or government actions can sen

d them running away. When they run, there is nobody to take their place except for bears. As of today, they are not running.

Bullish traders can sometimes become frustrated by the market's failure to cooperate in sending prices higher. When prices remain stagnant for extended periods, the bulls sometimes take matters into their own hands, forcing prices higher. At times prices can rise dramatically, seemingly without any catalyst, but with the appearance that prices are merely going up because nobody wants to be left on the sidelines during a rally. This frustration is revealed by the Long Straddle/Strangle Index (LSSI). This week, the LSSI is normal, however it is very close to a level that indicates frustration among bulls. Frustrated bulls can spark some truly unexpected rallies, but they can also get so frustrated that they walk away. When they walk, the bears are more than happy to take their place. As of today, they are not yet walking away.

What we are left with is a market dominated by bulls (CCNPI), with those bulls having little strength (LCMPI) and also becoming increasingly frustrated with the market's failure to break out of the range it has been stuck in for the past several months (LSSI). This is still a market with opportunity for growth, but a risky one in which to bet the farm.

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 consistently positive for over 13 months now, with only a couple of minor exceptions, which 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.

Although the LSSI is within normal limits this week, it is important to note that it is very near the edge of those limits. While not signaling that anything major is expected this week, the LSSI has the potential to move into a range that would indicate the market is “due for a breakout”. Such a move in the index could happen within the next week or so, and such moves are historically followed by some major moves in the market in the weeks that follow. The LSSI does not provide clues to the direction of potential moves, but it does put traders on notice that they should be prepared. With the LSSI so near its normal limits, this index bears watching.

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!”