By Chris Ebert

Option Index Summary

Covered call trading is one of the most popular styles of option strategies among retail traders, and for good reasons. The trades are simple, and they are profitable in strong bull markets, weak bull markets, sideways markets, slow downtrends and ordinary corrections. The only times they are losing trades are when there is a true bear market or during a crash.

To open a covered call, a trader simply buys 100 shares of a stock or ETF and then sells one call option. The trader gets to keep the call option premium whether the stock price goes up or down. So it is possible to profit on a stock, even as the price declines, as long as the option premium is sufficient to offset the decline.  It is important to note that covered calls are not without risk, and losses can be sudden and severe.

Because covered calls are profitable in all but the worst market conditions, their returns represent a bellwether of sorts, especially when they are opened on broad-based ETFs such as DIA (Dow Jones), QQQ (Nasdaq) or SPY (S&P 500). Profitability indicates a healthy market, while losses signal trouble.

Of course all covered calls are not created equal. Their profitability is highly dependent on both the strike price of the call option and its expiration date. For that reason, a specific type of covered call tends to be more indicative of market conditions than others:

  • Strike price of the call option is nearly the same as the underlying share price (at-the-money)
  • Expiration is several months away when the call option is sold (112 days to expiration is useful)Covered Call Trading

Looking back over the 2012 trading year, covered calls that met the above criteria, using an ETF that tracks the S&P 500, have been profitable every week except for two. Small losses occurred on these trades which expired the last week of May and again at the beginning of July, during a time when the S&P was undergoing a nearly 150 point correction. With only a few short weeks to go in 2012 it is quite possible that covered call trading could end up with a record of 50 wins and 2 losses for the year.

The Covered Call/Naked Put Index (CCNPI) tracks the profitability of these trades, and the index remains positive again this week, indicating the continued presence of bullishness among traders. However, bullishness in and of itself is not a reliable predictor of future market performance. The Long Call/Married Put Index (LCMPI) has shown significant weakness in the market for several weeks now, and casts some doubt on the sustainability of the recent uptrend. The Long Straddle/Strangle Index (LSSI) returned to normal this week, but remains at a low level that often signals a major move in the market. While traders remain bullish today (CCNPI), it would not take too much bad economic news to act upon the weakness of those bullish emotions (LCMPI) and result in a major sell-off (LSSI). However, absent a bad news catalyst, the trend of the S&P remains up.

Option Index Definitions

The intent of each option index is to provide a snapshot of the emotions of traders. It is these emotions that drive the markets over the long term, not the news; the news is merely a catalyst that feeds into market emotions that were already present.

  • The performance of Covered Calls and Naked Puts reveals whether traders feel bullish or bearish.
  • The performance of Long Calls and Married Puts reveals whether traders feel a bull market is strong or weak.
  • 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.

Covered Call/Naked Put Index (CCNPI) – Continued BULLISH

Because sellers of at-the-money covered calls or naked puts receive a premium from the buyer, either of those trades will result in a profit as long as the underlying price does not fall by a greater amount than the premium received. Generally, when covered calls or naked puts are profitable trades, it is an indication of a bull market. Likewise, when there is a bull market, it is often profitable to sell covered calls or naked puts.

An analysis of the performance of covered calls or naked puts opened a moderately long time prior to expiration (such as 112 days) can be useful:

  • In a downtrend – Implied volatility is usually higher than usual and the premiums received on these trades are also higher. It is therefore possible for covered calls or naked puts to become profitable when prices are still falling, but no longer falling quickly enough to outpace the faster time decay of the unusually high premiums. Thus a positive 112-day CCNPI in a downtrend is often a bullish signal that marks the end of a downtrend, while a negative CCNPI generally signals that the downtrend will continue.
  • In an uptrend – Implied volatility is generally low and the premiums received are lower as well. Covered calls and naked puts become much more sensitive to corrections in an uptrend, because there is a smaller premium to offset any decline in the underlying stock price. Thus a negative 112-day CCNPI often indicates the market has experienced more of a correction than would be expected in a healthy bull market. A negative 112-day CCNPI in an uptrend is a bearish signal that may mark the end of an uptrend, while a positive CCNPI generally signals that the uptrend will continue.

The 112-day CCNPI has been positive since mid-July and remained positive this week, and therefore is an indication of bullish emotions among traders.  Traders “want” to be bullish now, but they need strength to actually act bullish. Determining the strength of these bullish emotions requires a study of the Long Call/Married Put Index (LCMPI).

Long Call/Married Put Index (LCMPI) –Continued WEAKNESS

Because buyers of at-the-money long calls or married puts must pay a premium, these trades will only result in profits when the uptrend occurs quickly enough to offset the loss of value due to time decay. When long calls or married puts are profitable trades, it is an indication of a strong bull market. Likewise, only when there is a strong bull market is it profitable to buy calls or married puts.

An analysis of the performance of long calls or married puts opened a moderately long time prior to expiration (such as 112 days) can be useful:

  • At the beginning of an uptrend – Implied volatility usually remains elevated for some time after the previous downtrend has ended, causing the premiums paid to open long calls or married puts to be higher than usual. Long calls and married puts only become profitable when the market has gained sufficient strength to overcome the inflated premiums. Thus, when a previously negative 112-day LCMPI turns positive, it often signals that a bull market has gained strength.
  • When an uptrend is well underway – Implied volatility is generally low, and the premiums paid are much lower. Long calls and married puts only become unprofitable when the market has weakened so much that it cannot overcome the relatively low premiums. Thus, a when a previously positive 112-day LCMPI turns negative in an uptrend, it often signals that a bull market is weakening.

The 112-day LCMPI has been negative for several weeks now, indicating that bullish emotions are likely to be weak. Weakness is sometimes temporary, however weakness that lasts for more than a few weeks often leads to a bear market. If strength does not return within the next week or so, the chances of a sell-off will likely increase. Determining whether the bullish emotions, as shown by the CCNPI, and weakness of those emotions, as shown by the LCMPI, are justified requires a study of the Long Straddle/Strangle Index (LSSI).

Long Straddle/Strangle Index (LSSI) –  Returned to NORMAL

Because buyers of straddles or strangles must pay two premiums, one for the call option and another for the put option, these trades will only result in a profit when the market moves up or down very strongly, so that the gains exceed the combined premiums. When a long straddle or strangle returns a substantial profit it is an indication that traders were taken by surprise – they were complacent and those emotions were later proven to be unjustified when the market moved much more than they had expected.  Likewise, when the market is complacent, it can be profitable to buy a straddle or strangle.

When a long straddle or strangle results in a substantial loss, it is also an indication that traders were taken by surprise – they were overly-fearful and those fears were subsequently proven to be unjustified by the market’s failure to move.

An analysis of the performance of long straddles or strangles opened a moderately long time prior to expiration (such as 112 days) can be useful:

  • In any trend, up or down – The relatively high premium on these trades tends to make them rarely return a profit greater than 4%.  Thus, a 112-day LSSI that exceeds 4% often signals that the market has come too far, too fast and may need a correction to satisfy those traders who were previously complacent and subsequently surprised by the move.
  • In a range-bound market – The relatively high premium on these trades tends to result in losses, but those losses seldom exceed 6%. A 112-day LSSI that is negative by a greater magnitude than 6% is an indication not only that many traders were previously fearing a sell-off, causing an increase in option premiums, but that such a sell-off did not materialize. Thus a 112-day LSSI lower than -6% often precedes a breakout, either to a lower price range that confirms trader’s prior fears, or to a higher price range that completely puts those fears to rest.

The 112-day LSSI last exceeded its normal range this past August, just prior to the breakout to higher prices that occurred in early September. Two weeks ago the LSSI exceeded its normal range again, and was immediately followed by a rally. This week the LSSI stands at -5.2%, which is very near the maximum range of -6% that is considered normal. Often when the LSSI reaches these levels, the market makes some big moves in the following weeks. The direction of the move can be up or down depending on the news that triggers it, but the magnitude of the move tends to be amplified when the LSSI is at its current level. The remainder of 2012 could prove to be an interesting, and perhaps difficult time for traders.

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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Rest Of 2012 Could Depend On This One Trade

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