Option Trader's Emotions Are Shifting

By Chris Ebert

All three option indices experienced changes this week, signaling a shift in the emotions of traders. When emotions change, trading patterns tend to do so as well. The most notable difference this week was in the Long Call/Married Put Index (LCMPI), which saw all three measurement periods sink into negative territory for the first time this year. The Index is an indicator of the strength of a bull market, and the switch from positive to negative performance is therefore a strong indication that the 2012 bull market has ended. A special report will be available here later this weekend that explains possible ways to structure stock and option trades to deal with the new trading patterns likely to accompany the current changes in emotion, so be sure to check back for that update.

As readers were alerted here in previous updates, the LCMPI was in danger of being tripped due to the recent downturn in the S&P that began in early April. Because at-the-money long call options or married puts only return a profit in a strong bull market, by tracking the returns over 112-day, 28-day, and 7-day periods the LCMPI measures the strength of a bull market. When all three of these option trades fail to yield a profit, as was the case this week, it can be inferred that a bull market has lost all of its strength. The Index requires agreement among all three time frames in order to trip between bullish or non-bullish, so this week's change is a significant event.

The end of a bull market can be followed by a period of consolidation in which stock prices tend to move sideways, often becoming range-bound while waiting for a catalyst sufficient enough to cause a breakout. If that breakout is to the downside, a change in the LCMPI to non-bullish can sometimes mark the beginning of a bear market.

To determine whether the change in the LCMPI represents a correction or a bear market it is often helpful to look at the Covered Call/Naked Put Index (CCNPI). The CCNPI measures bullishness or bearishness regardless of trend strength. Since the premiums on options increase with volatility as fear of a downturn builds, at-the-money covered calls or naked puts only result in losses in a true bear market. Minor corrections or slow downtrends limit the profitability of these trades, but do not usually result in losses. The CCNPI weakened considerably this week, but not enough to give a clear signal of a bear market. The 112-day period continues to hold in profitable territory, where it has remained since early December 2011. From an option trading standpoint the market is experiencing a correction, although a dip in the SPX below 1265 next week would alter that view.

A final look at market emotion involves the Long Straddle/Strangle Index (LSSI) which measures the justification of market emotions. Long straddles or strangles are only profitable when the market moves in a way that takes traders by surprise. The 28-day and 7-day LSSI both retook positive ground this week, indicating that the recent selloff was somewhat stronger than expected. Generally, emotions can be considered unjustified when these trades return profits exceeding 5%, at which time the market is showing that trader's emotions are out of touch with reality. Given that the Index has not yet exceeded a 5% return for any of the three periods, the market can be considered to be functioning normally, and traditional technical and fundamental analysis should be effective.

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”.

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