What Options Say About Washington Debt Deal

By Chris Ebert

Stocks and Options at a Glance

As mentioned here repeatedly, the news does not control the stock market. News is simply a catalyst that increases the rate at which traders act upon emotions that were already present. Therefore, if those emotions are known ahead of time, it becomes easier to predict the possible outcomes of any news that may act as a catalyst.

With all eyes currently focused on developments in Washington, barring any unforeseen disaster outside of Washington (earthquake, war, etc.) the next catalyst is likely to come out of Washington. Exactly how news of a deal on debt negotiations, or a lack of a deal, will affect stock prices depends on the current emotions of traders. Those emotions can be revealed by analyzing three types of option trades:

Covered Calls and Naked Puts are currently profitable, indicating traders are generally bullish and want to push stock prices higher.
Long Calls and Married Puts are also profitable, which indicates that traders are not just a little bullish, but strong and highly confident that stock prices will move higher soon.
Long Straddles and Long Strangles are not profitable, but are not experiencing excessive losses either, indicating stock prices could move much higher before traders start to feel the market is becoming over-bought.

The emotions are overwhelmingly bullish. Of course that's not a guarantee that the market will soar if news of a deal in Washington acts as a catalyst. While there is no way to predict the future with certainty, the current emotions portrayed by the performance of stock option trades suggests that such news would tend to favor a bullish move over the coming weeks, even if the initial reaction ends up being a sell-the-news event.

Click on chart to enlarge

*All strategies involve at-the-money options opened 4 months (112 days) prior to this week's expiration using an ETF that closely tracks the performance of the S&P 500, such as the SPDR S&P 500 ETF Trust SPY

Weekly 3-Step Options Analysis:

On the chart of “Stocks and Options at a Glance”, option strategies are broken down into 3 basic categories: A, B and C. Following is a detailed 3-step analysis of the performance of each of those categories.

STEP 1: Are the Bulls in Control of the Market?

The performance of Covered Calls and Naked Puts (Category A+ trades) 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 past week, Covered Call trading and Naked Put trading were both profitable, as they have been for an extended period. In fact, Covered Call trading became profitable in late 2011 and has remained profitable every week since then except for two very minor losses. That means the Bulls have been in control since late 2011 and remain in control today. As long as the S&P remains above 1547 over the upcoming week, the Bulls will retain control of the longer-term trend. 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.

• “If stock prices have been falling long enough to have caused extremely high implied volatility, as measured by indicators such as the VIX, and I can collect enough of a premium on a Covered Call or Naked Put to earn a profit even when stock prices fall drastically, the Bears have lost control.” It's probably very near the end of a Bear market.

STEP 2: How Strong are the Bulls?

The performance of Long Calls and Married Puts (Category B+ trades) 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.

Long Call trading has been profitable for most of 2013 except for a brief break from August through early October. The break in that historically long streak of profitability marked an important shift in bullish confidence; the Bulls lost the strength they had earlier in the year. This was evident in the recent failed attempt to break the 1710 weekly-close record on the S&P. The Bulls have since gained confidence, as revealed by the return of profits on Long Call trading. Only if the S&P closes the upcoming week below 1666 will Long Calls fail to profit, suggesting the Bulls have lost confidence and strength. 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, they are also 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 or Bears Overstepped their Authority?

The performance of Long Straddles and Strangles (Category C+ trades) 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.

The LSSI currently stands at -1.4%, which is normal. Such levels suggest that option traders have had a good handle on predicting the future. In other words, nothing in the current stock market has come as a surprise to option traders. For now, that means there is no reason for the stock market to experience a correction, nor is there a reason for it to break out of its current range unless economic developments warrant such a move. That is a contrast to periods in which a correction or breakout is warranted purely on past performance of stock prices without regard for future economic news. Sometimes the market is like a barroom brawler saying “Just give me a reason!” Other times it's more reminiscent of the cooler heads saying “I'm not going there without a good reason!” The current market is the latter, and it will make a big move if provoked, but only if provoked. 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 just been moving quickly, but at a rate that is surprisingly fast.” Profits warrant concern that a Bull market may be becoming over-bought or a Bear market may be becoming over-sold, 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 trend has been ridiculous and unsustainable.” No matter how much strength the Bulls or Bears have, they have pushed the market too far, too fast, and it needs to correct, at least temporarily.

• “If I pay both premiums and suffer a loss of more than 6%, then the market has become remarkably trendless and range bound.” The stalemate between the Bulls and Bears has gone on far too long, and the market needs to break out of its current price range, either to a higher range or a lower one.

*Option position returns are extrapolated from historical data deemed reliable, but which cannot be guaranteed accurate. Not all strike prices and expiration dates may be available for trading, so actual returns may differ slightly from those calculated above.

Updates to the above analysis may be found at @optionscientist

Questions, comments and constructive criticism are always welcome. Enter them in the comment box below, or send them to OptionScientist@zentrader.ca.

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!”