Option Indices Update – Proceed With Caution

By Chris Ebert

Although the market was oversold early this week, late-week buying did little to change the option indices. The Covered Call/Naked Put Index (CCNPI) showed some signs of improvement, but remained in bearish territory. The Long Call/ Married Put Index (LCMPI) continued to show no signs of bull market strength, while the Long Straddle/Strangle Index (LSSI) indicated that market emotions remained within normal limits.

Traders looking for a way to go long in the market despite the lack of strength indicated by the option indices may want to consider a ratio bull call spread. While no option trade can eliminate all risk, ratio spreads are very efficient at capturing moves in one direction without much risk if the market goes the other way. They are also very slow at realizing maximum loss, and losses can usually be reduced significantly by closing if the trade is in an unfavorable position a day or two before expiration.

The choice of a ratio bull call spread this week is based on some improvement in the CCNPI. At-the-money covered calls and naked puts are often the first types of option trades to begin showing profits when an uptrend begins. The CCNPI is still showing bearish tendencies, so the relative safety of a ratio spread seems warranted.

As might be expected, long calls and married puts have not performed well lately due to the recent sell-offs in the market. The LCMPI is showing very little in the way of strength, which suggests that using options to limit downside risk is currently worthwhile.

Long straddles and strangles have performed as expected for most of 2012, and as a result the LSSI was mostly unchanged this week. The market, although much more volatile now than earlier in the year, is still very tradable if stop-losses or options are used to limit risk.

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”.