3 New Indexes To Interpret Market Emotions

By Christopher Ebert

Today, three new indexes are being introduced as an aid to traders. Each index provides additional insight into the current conditions of the stock market that may be helpful to stock traders as well as option traders. Over the coming weeks and months I will be analyzing these option indices and reporting my findings on Zentrader to see if the current emotion of the market is justified based on past performance. I believe it will be much more useful for studying volatility than simply using the VIX as an indicator and it's my goal to provide you with a trading tool to give you an edge in the markets.

The first of these is the Covered Call/Naked Put Index (CCNPI) measures the efficiency of either an at-the-money covered call or naked put.

Generally, when the Index is positive it is an indication of a bull market while negative values indicate weakness. The Index becomes a more accurate indicator when it is tracked over differing contract lengths that have the same expiration. A chart of the CCNPI in which the 112-day performance is greater than the 28-day performance, which in turn exceeds the 7-day performance, is a strong bullish indicator, while the opposite indicates bearish sentiment. Mixed performance is often a signal of correction or reversal.

The next is the Long Call/Married Put Index (LCMPI) measures the performance of either strategy using at-the-money options of differing lengths but the same expiration.

The LCMPI is affected differently by volatility than the CCNPI. As fear decreases, premiums become lower. While the lower premiums increase the profitability of shorter-term options, the faster rate of time decay tends to offset the performance. A chart of the LCMPI in which the 112-Day, 28-Day, and 7-Day performances are all positive is a strong bullish indicator, the opposite indicates bearishness, and mixed performance often precedes changes in the markets.

Option Strategies

The final is the Long Strangle/Straddle Index (LSSI) measures the justification of fear in the market.

When either strategy performs extremely well or extremely poorly, it is because the level of implied volatility at the time the trade was opened was unjustified. In general, values within a range of -5% to +5% indicate a normally functioning market.Readings outside of that range are an indication that emotions are controlling the market more than usual. At levels exceeding 5%, traditional fundamental and technical analysis is often insufficient for profitable trading and the market becomes a gambling casino.

All Index values are calculated relative 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 following 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 with anyone who is interested.