Summer Doldrums Evident In Option Indices

By Chris Ebert

Option Index Summary

Over the past several months, the three major option indices have been updated here each week in order to give readers insight into the market's emotions. These indices are provided as additional tools for traders to gain a better understanding of how the market is likely to react to catalysts, such as economic reports or other news, given the current general emotions of most traders. A graphical representation of these past option posts depicts how options can help predict market behavior.

The indices are showing little change from the previous week. The Covered Call/Naked Put Index (CCNPI) remains mildly bullish, but the Long Call/Married Put Index (LCMPI) indicates very little in the way of bull-market strength. The Long/Straddle Strangle Index (LSSI) is mostly within normal limits, but with a bias toward the overly-fearful end of the spectrum. So what does this mean for traders?

Because there are still bullish emotions, some additional upside movement in the S&P 500 is definitely possible. But because of the lack of strength of conviction behind that bullishness, any rallies will tend to be modest unless some surprisingly good economic news is revealed. The fact that longer term LSSI is in the “overly-fearful” range is an indication that some traders were expecting a more intense correction than what actually occurred during the sell-off from April through June. Because their fears were not fully realized, many will be reluctant to go long now, and some may be waiting for an opportunity to initiate shorts. The current lack of any real direction or strength is a common feature during the summer doldrums.

Covered Call/Naked Put Index (CCNPI) – Mildly Bullish

At-the-money covered calls and naked puts continued to be profitable this week, as they have consistently done since early June. The worst performing trades among the three time periods was the 7-day, which broke even. The ability of covered calls and naked puts to return profits for several weeks in a row is a bullish sign. But with the VIX hovering in the upper teens, the premiums collected on these trades has been relatively low. So while their performance has been positive, the amount of bullish sentiment that can be inferred from that performance is not impressive.

Long Call/Married Put Index (LCMPI) – Weak

The premiums to open at-the-money long calls or married puts have been fairly low in recent weeks due to the low level of implied volatility. But even with low premiums, these trades have mostly failed to be profitable. Most notably among these trades are those opened 112 days before expiration, which have not been profitable since early May. If a long call or married put cannot make a profit when the VIX is reasonably low, the market is not giving off signs of bullish strength.

Long Straddle/Strangle Index (LSSI) – Normal to Overly Fearful

As is most often the case, long straddles and strangles were losing trades again this week. However, a pattern has emerged over the past several weeks that is worth noting. Long term trades, those opened 112 days prior to expiration, have begun to show losses that exceed 5%. Losses of such magnitude usually only occur when the trades were opened at a time of elevated volatility, and the market subsequently failed to experience a major move. Just because the move did not happen as expected does not mean that it will not happen – ever.

As long as the LSSI is in the “overly-fearful” range, there will be a percentage of traders waiting to prove that their fear was in fact justified. If the percentage is high enough, their combined sentiment can be a driving force behind short selling events that exacerbate any future downturns. If such a downturn never materializes, the LSSI eventually returns to “normal”.

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”.