By Chris Ebert
Option Index Summary
The current condition of the market can be summed up in three easy steps by looking at the profit or loss of some common option trades. Each set of option trades is used to calculate an option index. Each of the three option indexes provides a snapshot of emotions among traders.
STEP 1: Are the bulls in control?
The performance of Covered Calls and Naked Puts reveals whether traders feel bullish or bearish.
The Covered Call/Naked Put Index (CCNPI) was positive again this past week. The CCNPI has become a sort of broken record lately, with covered call trading or naked put trading each resulting in gain after gain after gain. In fact, covered calls on the S&P, opened at-the-money, four months prior to expiration, have profited for 58 of the past 60 weeks now. When covered call trading is profitable the CCNPI is positive, and when the CCNPI is positive it means that the bulls are in control of the market.
STEP 2: How strong are the bulls?
The performance of Long Calls and Married Puts reveals whether bullish traders confidence is strong or weak.
The Long Call/Married Put Index (LCMPI) continues to show weakness among the bulls this week. As has been the case for several weeks now, although the trend has generally been up, this is by no means a strong bull market, at least not yet.
STEP 3: Are we in for any surprises?
The performance of Long Straddles and Strangles reveals whether traders feel the market is normal, has come too far and needs to correct
Long Straddles and Strangles on the S&P 500 were losing trades this week, no matter whether they were opened a week ago, a month ago or four months ago. That is bad news for folks who chose to open those types of option trades, but good news for the rest of us.
It is normal for straddles or strangles to produce losses, provided those losses are not excessive. Losses indicate that the S&P has not made any surprising moves recently. That's a good thing, because surprises tend to increase emotions and cause traders to act erratically. Surprises beget surprises – so one unexpected move in the S&P can cause the market to become unpredictable for weeks, sometimes months.
The Long Straddle/Strangle Index (LSSI) measures the profit and loss of those types of option trades. This week the LSSI is within normal limits. It can therefore be inferred that the market will not make any surprising moves in the next week or so, unless there is some truly surprising economic news.
Option Index Details
The following is a graphical representation of each option index along with the method of calculation and the theory behind its use in determining market emotions.
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, which is an indication of bullish emotions among traders. In 58 of the past 60 weeks, the bulls have controlled the market, and they retain control this week. 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 sometimes 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 has flirted with abnormally low values over the past several weeks, but it has now returned to normal. Normal readings generally indicate that the market is not being excessively influenced by emotions. Economic news and other catalysts can generally be expected to have effects on prices that are proportional to their magnitude.
While it is not impossible to experience a huge rally or a crash when the LSSI is normal, these events generally only follow truly surprising economic developments. In comparison, when the LSSI is abnormal, surprise rallies or crashes may occur when the market makes a huge overreaction to a relatively small economic development. This week's normal LSSI is good news for traders who don't like surprises.
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!”
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