Market's Thermostat Ain't Broken – So Says LSSI

 

By Chris Ebert

Option Index Summary

The Long Straddle Strangle Index (LSSI) is a strong indicator of the collective amount of surprise among traders of the stocks that make up the S&P 500. In general, it fluctuates between:

• “Who would have expected that the market would have moved this much?”

and

• “Can you believe how long the market has been stuck in this range?”

Either of those statements represents surprise at the rate of change of stock prices – either surprisingly fast or surprisingly slow. When the LSSI exceeds +4% it is an indication that stock prices have moved faster than most traders expected. When it falls below -6% it is an indication that the market has been surprisingly range bound.

There are hundreds of technical indicators available, but there is one quality that sets the LSSI apart from many of them. The LSSI tends to act like a thermostat. That is, once it reaches its limit, it tends to move in the other direction until it reaches the opposite limit within several weeks to a few months. This quality can be seen in the chart of the LSSI presented later in this article. It contrasts greatly from indicators in which reaching a limit has very little correlation with reaching the opposite limit.

Moreover, when the LSSI exceeds its limit, it also tends to exceed the opposite limit by a similar magnitude. For example an LSSI of +10% is often followed by an LSSI of -10% within a month or so.

What does this mean to traders? The LSSI exceeded its +4% limit back on March 9th. In and of itself, such an occurrence often signals an upcoming significant correction in the S&P. Since then it has backed off a bit, so that it stands at +3% this week. If past performance holds true, it would be expected that the LSSI is now on its way towards -6%.

Of course, no indicator is accurate 100% of the time. But past performance strongly suggests that not only is the market due for a newsworthy correction within the next several weeks, but that within the next couple of months the LSSI will tag the -6% limit. At that level traders will begin to ask “Can you believe how long the market has been stuck in this range?” So, traders should expect some upcoming choppy sideways action over the next few months, in addition to a possible correction.

An LSSI exceeding +4% generally does not signify a correction which evolves into a bear market. Most times the correction is just a temporary pullback. The distinction between “temporary correction” and “beginning of a bear market” usually comes when the LSSI has first hit +4% and then declined to -6%. At this time, a -6% LSSI is not a concern; at +3% the LSSI has a long way to go in order to reach -6%. If a -6% LSSI arises over the next month or so, that is when bear market concerns should be considered.

It should be noted that the LSSI occasionally makes what might be called a “double top”. That is, it exceeds its 4% limit, backs off slightly, and then exceeds it again. If that were to occur, we could be looking at a few more record highs for the S&P in the short term. But such a move would likely be temporary, as such action would again cause the LSSI to signal that the market was “due for a correction”.

The LSSI, when combined with the two other option indices, provides a comprehensive view of the stock market. The Covered Call/Naked Put Index (CCNPI) is currently bullish, which really isn't a surprise. The Long Call/Married Put Index (LCMPI) indicates strength behind that bullishness, again not very surprising given the market's recent performance. The 3 step process of analyzing the option indices is detailed below.

STEP 1: Are the Bulls in control of the market?

The performance of Covered Calls and Naked Puts reveals whether the Bulls are in control. The Covered Call/Naked Put Index (CCNPI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames. Most important is the profitability of these trades opened 112 days prior to expiration.

This week, covered call trading and naked put trading were both profitable, as they have been for an extended period. In the past 112 days covered call trading has returned a 3.5% profit. That means the Bulls remain in control. The reasoning goes as follows:

• “If I can sell an at-the-money covered call or a naked put and make a profit, then prices have either been going up, or have not fallen significantly.” Either way, it's a Bull market.


• “If I can't collect enough of a premium on a covered call or naked put to earn a profit, it means prices are falling too fast. If implied volatility increases, as measured by indicators such as the VIX, the premiums I collect will increase as well. If the higher premiums are insufficient to offset my losses, the Bulls have lost control.” It's a Bear 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) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames. Most important is the profitability of these trades opened 112 days prior to expiration.

This week, long call trading and married put trading were both profitable. Both forms of trading became profitable in late January. In the past 112 days long call trading has returned a 6.5% profit. That means the Bulls are not only in control now, but they are confident and strong. The reasoning goes as follows:

• “If I can pay the premium on an at-the-money long call or a married put and still manage to earn a profit, then prices have been going up – and going up quickly.” The Bulls are not just in control, but they are showing their strength.


• “If I pay the premium on a long call or a married put and fail to earn a profit, then prices have either gone down, or have not risen significantly.” Either way, if the Bulls are in control they are not showing their strength.

STEP 3: Have the Bulls overstepped their authority?

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. The Long Straddle/Strangle Index (LSSI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames. Most important is the profitability of these trades opened 112 days prior to expiration.

On March 9^th, long straddle trading and long strangle trading reached rare and absurd levels of profitability. Profitability in and of itself is a signal that the market is doing something strange; but profitability over the past two weeks has been over the top, exceeding 4%, a level that is simply unsustainable. This past week, expiring long straddles (that were opened 112 days ago) returned a 3% profit. Such levels normally precede a correction. That does not preclude a possible move higher prior to the correction though.

Just because the LSSI is warning of an upcoming correction does not necessarily mean that this is a good time to go short. It just means that the market cannot continue at its current pace without running out of buyers. Often a correction occurs within a week of the LSSI exceeding 4%, but there are times when the market tacks on several weeks of large gains before it corrects. The reasoning goes as follows:

•  “If I can pay the premium, not just on an at-the-money call, but also on an at-the-money put and still manage to earn a profit, then prices have not only been going up quickly, but have gone up surprisingly fast.” Profits warrant concern that the market may be becoming over-extended, but generally profits of less than 4% do not indicate an immediate threat of a correction.


• “If I can pay both premiums and earn a profit of more than 4%, then the pace of the uptrend has been ridiculous and unsustainable.” No matter how much strength the Bulls have, they have pushed the market too far, too fast, and it needs to correct

Conclusion

The CCNPI currently indicates a bull market and the LCMPI confirms that the bull market has strength. But the LSSI presents a reason to be cautious. Levels of the LSSI that have been reached in the last two weeks often precede a significant short- to intermediate-term correction in the S&P. Such corrections often lead to a range bound market that lasts for a month or so. Occasionally a short-term correction turns out to be the beginning of a bear market. There are currently no indications of an upcoming bear market, but an LSSI of less than -6% would require a re-evaluation of that possibility, should it occur within the next month or so.

*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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