Option Indices Signal Bear Market

By Chris Ebert

Changes in the option indices are an indication of changes in the emotions of traders. When the market is in an uptrend, a weakening of the Long Call/Married Put Index (LCMPI) can be a signal that the trend may be ending. Changes in the LCMPI often point to changes in sentiment before other indicators such as the VIX begin showing an increase in fear.

As implied volatility decreases during a bull market, the lower premiums on at-the-money long calls and married puts causes these trades to be profitable even if the trend weakens. If they become unprofitable, especially over more than one of the 7-day, 28-day and 112-day time periods measured, it is an indication that trader's emotions are no longer bullish. The LCMPI began signaling weakness at the beginning of April and became decidedly non-bullish at the beginning of May, indicating that the 2012 Bull Market had ended. Readers here were alerted to those changes in previous updates.

In a down trending market, implied volatility increases the premiums received on at-the-money covered calls and naked puts. When these trades are showing profits during a downtrend, it is often a sign that the market is experiencing a correction. However, when the Covered Call/Naked Put Index (CCNPI) is negative for all three time periods, it is a strong indication that a bear market has taken hold.

 The CCNPI is now negative for the 7-day, 28-day and 112-day periods for the first time this year. When covered calls and naked puts consistently lose despite the increase in premiums due to volatility, the market is experiencing much more than a simple correction.

The Long Straddle/Strangle Index (LSSI) measures the justification of fear. These types of trades are only profitable when price movements take the majority of traders by surprise. As might be expected with the magnitude of the recent selloff, long straddles and strangles have shown some profits, but they have not yet exceeded the 5% level that would indicate an all-out crash.

All Index values are calculated relative to the S&P 500 using volatility data to extrapolate the theoretical performance over the given time periods. It is not possible to match the exact performances shown because the strike prices and expiration dates available in actual trading will always differ from those used in the calculations.

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”.