By Chris Ebert

Option Index Summary

All markets become irrational from time to time, including the stock market. An irrational market can be extremely frustrating for traders. It’s frustrating because an irrational market is driven primarily by emotions.

Take the current market for example: While there are many factors that led to the recent all-time highs for the Dow and the S&P, one of the biggest factors is a form of “lottery fever”. Just as increasing lottery jackpots tend to increase demand for lottery tickets, which in turn causes an increase in the jackpot, and so on… and so on… increasing stock prices sometimes are themselves a driving influence that causes subsequent increasing stock prices.Lottery

With record highs making headlines on the evening news, folks who have shied away from stocks for years or decades are now likely to reconsider. And who can blame them?  However, a considerable portion of the funds now beginning to pour back in to stocks through retirement accounts such as 401Ks or IRAs or through online brokerage accounts are not suddenly being allocated to stocks because of signs of a fundamental shift towards a more robust economy. Instead, they are being allocated towards stocks because of lottery fever.

A healthy market needs to correct itself occasionally. Corrections help define levels of support and resistance, and thus help traders feel more confident. Confident traders help keep bull market rallies running strong. But lottery fever tends to disrupt the normal correction cycle. What we are left with is a market that is overdue for a correction. The recent rally is running on borrowed time, supported mostly by the presence of lottery fever.

How long lottery fever will last is anybody’s guess, but its presence can be monitored by the Long Straddle/Strangle Index (LSSI). Whenever the LSSI is elevated in an uptrend, it is an indication that buyers are entering the market based on their emotions; they don’t want to miss out on the stock market lottery. The LSSI has been at abnormally high levels since March 9th.

Often a correction of 10% or so ensues within weeks, once the LSSI reaches such high levels. However, lottery fever can postpone a correction for many weeks, and sometimes as long as a few months. To look at it another way, whenever the LSSI is elevated, the market is being irrational. This can be very frustrating for traders, because fighting an irrational market can be devastating. A famous economist once said:

“The market can remain irrational a lot longer than you or I can remain solvent.”

To illustrate just how uncommon the current condition of the market actually is, consider 5 traders, each using a different option strategy. Each trader opened a trade 112 days ago (December 21, 2012) using at-the-money options on the S&P 500 using an ETF known as the SPDR S&P 500 ETF (SPY). This particular ETF maintains a share price that is approximately 1/10th the value of the S&P 500. On December 21, the S&P was 1430 and SPY was trading at $143. At-the-money options (those at the $143 strike price) expiring this week had a premium of approximately $6 per share at that time.

  • Trader #1 sold covered calls on SPY at the $143 strike for $6 per share.
  • Trader #2 sold naked puts on SPY at the $143 strike for $6 per share.
  • Trader #3 bought a call from Trader #1 at $6 per share.
  • Trader #4 bought 100 shares of SPY at $143 and also a put from Trader #2 at $6 per share.
  • Trader #5 bought a call from Trader #1 and a put from Trader #2 for a total of $12 per share.

When all of the above options expired this week, the S&P was near 1589, so the share price of SPY was about $159.

  • Trader #1 sold all shares of SPY at $143 as obligated by the call option, which is a wash, but kept the $6 per share premium as profit. That works out to a gain of about 4% relative to the original share price of $143.
  • Trader #2 had the naked puts expire worthless, and kept the $6 per share premium as profit. That works out to a gain of about 4% relative to the original share price of $143.
  • Tramoney bagder #3 exercised the call option which granted the right to buy SPY shares at $143, and then sold those shares immediately for $159. The $6 per share premium is added to the cost basis of the shares, and the end result is a $10 per share profit. That’s a gain of about 7% relative to the original $143 share price.
  • Trader #4 had a put option that expired worthless, so the $6 per share premium is added to the cost basis of the shares, and the end result is a profit of $10 per share when the shares are sold for $159. That’s a gain of about 7% relative to the original $143 share price.
  • Trader #5 had a put option that expired worthless, but exercised the call option which granted the right to buy SPY shares at $143, and then sold those shares immediately for $159. The $12 per share in option premiums is added to the cost basis of the shares, and the end result is still a $4 per share profit. That’s a gain of about 3% relative to the original $143 share price.

Everybody made a profit! The covered call trader, the naked put trader, the long call trader, the married put trader and the long straddle trader each made a profit. That’s not something that happens very often, and it is often a sign of an irrational market.

Each of the above trades may be monitored in order to gain insight into the stock market. The Covered Call/Naked Put Index (CCNPI) tracks the profitability of covered calls (Trader #1) and naked puts (Trader #2). The Long Call/Married Put Index tracks the profitability of  long calls (Trader #3) and married puts (Trader #4). The Long Straddle/Strangle Index tracks the profitability of  combined long calls and puts (Trader #5). The detailed 3-step process of analysis is shown below:

STEP 1: Are the Bulls in control of the market?

The performance of Covered Calls and Naked Puts 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.

Covered Call Trading

This week, covered call trading and naked put trading were both profitable, as they have been for an extended period. That means the Bulls remain in control. 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.

STEP 2: How strong are the Bulls?

The performance of Long Calls and Married Puts 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

This week, long call trading and married put trading were both profitable. Both forms of trading became profitable in late January. It means the Bulls are not only in control now, but they are confident and strong. 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, but they are 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 overstepped their authority?

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. 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.

Long Straddle Trading

On March 9th, long straddle trading and long strangle trading reached rare and absurd levels of profitability. Such levels normally precede a correction. That does not preclude a possible move higher prior to the correction though.

Just because the LSSI is warning of an upcoming correction does not necessarily mean that this is a good time to go short. It just means that the market cannot continue at its current pace without running out of buyers. Often a correction occurs within a week of the LSSI exceeding 4%, but there are times when the market tacks on several weeks of large gains before it corrects.

Since March 9th the market has indeed tacked on several weeks of impressive gains, with the Dow and the S&P both reaching new all-time highs. Is the current market irrational? Yes. Is such irrational behavior unexpected? Not at all. Every market goes through phases of irrationality, and each phase eventually ends with a reversion to more rational behavior.

While the LSSI is a strong indicator of upcoming corrections, usually within weeks, there are also times when corrections occur several months after the initial LSSI signal. That does not mean the LSSI was wrong. Can anyone honestly say they would not welcome a sell-off at this point, if for no other reason than to buy the dip?

The current market is well overdue for a correction. The current rally is living on borrowed time. The correction will occur, eventually, but betting on a correction could potentially lead to bankruptcy. An elevated LSSI has always led to a correction in the past, and there’s no reason to suspect this time will be an exception. It’s just a matter of how long until it occurs. 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 only been going up quickly, but have gone up surprisingly fast.” Profits warrant concern that the market may be becoming over-extended, 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 uptrend has been ridiculous and unsustainable.” No matter how much strength the Bulls have, they have pushed the market too far, too fast, and it needs to correct

Conclusion

The CCNPI currently indicates a bull market and the LCMPI confirms that the bull market has strength. But the LSSI presents a reason to be cautious. Levels of the LSSI that have been reached in the last five weeks often precede a significant short- to intermediate-term correction in the S&P.

The current rally is living on borrowed time, and yet it shows no signs of giving up. Everyone knows a correction is on the horizon, and still the correction has not been ensued. If there is any comfort for those waiting impatiently for the next correction, the longer it has taken for a correction to begin after a signal from the LSSI, the deeper that correction has historically been.

*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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