By Chris Ebert

Who gets the bigger profit; Put sellers or Call buyers? It turns out the answer is as important for stock traders as it is for option traders.

Put options are really nothing more than insurance policies that pay a stock owner in case the stock price falls below a pre-determined level. For example, a $100 Put option will pay a stock owner for any losses that are incurred if the stock falls below $100 per share, where $100 is the “strike price” of the option.

As with any type of insurance policy, a premium is required in order to purchase it. So, a savvy trader, believing the stock price will rise, can actually sell a Put option and collect the premium. Just like an insurance company, the seller of a Put option will generally keep the premium as profit if the stock price does not fall below the agreed-upon price per share. So, it makes sense that Put sellers make money when stock prices rise.

Call options are insurance policies too, but whereas Puts insure stock owners against falling prices, Calls insure non-owners against rising prices. For example, in return for paying a premium, a $100 Call option insures someone who does not own stock against all of the profits that would be missed if the stock price climbed above $100 per share. So, it makes sense that Call buyers, as well as Put sellers, make money when stock prices rise.

Since Put sellers (also known as Naked Puts) and Call buyers (also known as Long Calls) both tend to profit in a Bull market, when stock prices are generally on the rise, both strategies are considered to be bullish. But the profits and risks of these two bullish strategies are quite different .It is therefore very important for an option trader to recognize which strategy is the better choice for the current market. And by twisting things around, the result – the better strategy – will reveal clues about the current market environment to a stock trader.

Before comparing profit size, it is important to know if either Naked Puts or Long Calls, or both, are currently profitable at all.

Stocks and Options at a Glance

Click on chart to enlarge

*All strategies involve at-the-money options opened 4 months (112 days) prior to this week’s expiration using an ETF that closely tracks the performance of the S&P 500, such as the SPDR S&P 500 ETF Trust (NYSEARCA:SPY)

You are here – Bull Market Stage 2 – the “digesting gains” Stage.

On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending June 21, 2014, this is how the trades performed:

  • Covered Call and Naked Put trading are each currently profitable (A+).
    This week’s profit was +3.1%.
  • Long Call and Married Put trading are each currently profitable (B+).
    This week’s profit was +1.3%.
  • Long Straddle and Strangle trading is currently not profitable (C-).
    This week’s loss was -1.8%.

Options Market Stages

Click on chart to enlarge

* All profits are calculated at expiration, as a percentage of the underlying $SPY share price, using options ATM-when-opened 4 months to expiration.

Using the chart above, it can be seen that the combination, A+ B+ C-, occurs whenever the stock market environment is at Bull Market Stage 2, known here as the “digesting gains” stage. It is so named because it often encompasses a period of consolidation (digestion) which follows a significant rally and often precedes the next leg up for stock prices in general.

Naked Put trading is currently much more profitable than Long Call trading. That’s not a coincidence; Naked Put trading is always more profitable than Long Call trading during Bull Market Stage 2. Put-selling’s profit is certainly something for option traders to consider, but it has implications for stock traders as well, as it indicates a widespread lack of euphoria.

For a description of Stage 2, as well as a comparison to all of the other stages, see the chart on the left (click to enlarge):

What Happens Next?

When Put sellers outperform Call buyers in Bull Market Stage 2, it signals a relatively rational stock market environment, when compared to the irrational euphoria of the “lottery fever” of Bull Market Stage 1. Thus, if you are not feeling euphoria at the moment, remember that you are likely not alone, so trade accordingly.

Options Market Stages 06-28-2014

As seen in the chart above, the S&P would need to soar to near 2000 in the coming week or so, in order for the euphoria of Bull Market Stage 1 to resume.

A lack of euphoria isn’t necessarily bad news for stock prices. It just means prices are currently likely to be more influenced by news events and less by recent market performance. In a roaring Bull Market Stage 1, under the influence of lottery fever, stock prices often rise simply because they have recently risen. Quickly rising prices draw buyers from the sidelines, causing prices to rise even more, creating further euphoria.

When the market is digesting gains, in Bull Market Stage 2, traders tend to deliberate and weigh good news, only pushing stock prices higher if they believe the news justifies it. At the same time, there is a tendency to drive prices lower if bad news is sufficient, and the effect can be magnified by a lack of euphoria and an accompanying lack of a willingness to “buy the dip no matter what”.

While the implications of a lack of euphoria are fairly straightforward for stock traders, it is not quite so simple for option traders. While it is true that, for the specific options presented above, Put sellers are currently earning more profits than Call buyers, the Put sellers are also taking on a much larger risk of loss. Ultimately, it is not just the profit that matters, but the risk it took to earn that profit. As can be seen in the chart below, Put sellers can and do experience significant losses at times, the most notable recent losses being in 2011.

Selling Puts Vs. Buying Calls

It can also be seen that the trend over the past year or so has been for fewer and fewer instances of Call Buyers outperforming Put Sellers. Call buying, at least as far as at-the-money 4-month-out Calls on $SPY are concerned, seems to have lost its edge. A trader must either accept the diminishing returns of Long Calls, or else seek an alternative. An obvious alternative is Naked Put selling, but with a much higher risk potential.

When considering the trend of Long Calls outperforming Naked Puts, it may be worth considering that through such a trend a trader is being enticed to accept higher risk in order to maintain the same returns as previously were common. In other words, a lack of euphoria in the stock market is contributing to a less attractive environment for Call buyers, luring them into selling Puts instead, despite the increased risk, since selling Puts has had a stellar track record with virtually no losses since late 2011.

The end result is that a lack of euphoria tends to cause a drop in demand for Call buying; and a drop in demand in turn tends to lead to lower premiums. At the same time, the stellar track record of Put selling tends to increase the attractiveness of the strategy, leading to an increase in Put supply; and the increase in supply tends to lead towards lower premiums for Puts. Absent euphoria, lower demand helps drive Call premiums down; higher supply helps push Put premiums lower. When the premiums of Calls and Puts decrease, the effect is seen as a decrease in “implied volatility”.

Bull Market Stage 2 is a market environment that favors higher-risk higher-profit-probability Put selling over lower-risk lower-profit-probability Call buying. leading to too many Puts for sale and too few buyers of Calls to maintain the status quo. How are Put sellers going to find buyers for all of those extra Puts for sale, especially considering that the current Bull market is not one that makes stock owners feel an urgent need to insure their portfolios by buying Puts? They do it the same way Call sellers deal with dwindling numbers of buyers – by lowering the ask price until their offer becomes too good to refuse.

Option premiums often decrease drastically during Stage 2, so Stage 2  tends to be accompanied by a decrease in implied volatility. The implied volatility of the S&P 500 is one of the most widely known indicators in use today – the VIX. Bull Market Stage 2 tends to drive implied volatility down, resulting in low values for the VIX.

The recent low levels of the VIX, which are some of the lowest on record, can therefore be attributed, at least in part, to the presence of Bull Market Stage 2 and its lack of euphoria. Perhaps counter-intuitively, it is the lack of euphoria – the lack of go-go “lottery fever” days that were so common in 2013 – that has helped push the VIX to record lows.

Strange as it may seem, the euphoric lottery fever of Bull Market Stage 1 actually favors a somewhat higher VIX than the digestion and consolidation of Bull Market Stage 2. Lottery fever, as it is defined here, exists when Long Call profits exceed Naked Put profits, thus demand for Calls may be higher while supply for Puts may be lower, effectively driving both premiums higher. Call buyers may be willing to pay higher premiums during Stage 1 than they would during Stage 2, because the euphoria gives them a good chance of earning a relatively large profit with limited risk. Put buyers may be willing to pay higher premiums to insure their skyrocketing stocks, since their pockets are overflowing with extra cash. Higher premiums result in a higher level of the VIX, since option premiums are used to calculate the VIX.

All traders need to be aware that the VIX, which commonly functions as a fear index, can be misleading when Bull Market Stage 2 is underway. Extremely low levels of the VIX may give the illusion that fear is decreasing in regard to S&P 500 stock prices. The truth is that such low levels are at least partly attributable to a lack of euphoria, not necessarily the disappearance of fear. In addition, future increases in the VIX from its current levels would not necessarily indicate an increase in fear, since a return of euphoria could also cause an increase. A decrease in fear, and an accompanying return to euphoria, would again make Call buying more profitable than Put selling, which would increase Call demand and decrease Put supply, leading to higher premiums for both types of options and thus a higher VIX, despite the decrease in fear.

Traders using the VIX as an indicator of fear would do well to remember that it is also an indicator of greed. Although fear tends to have a greater effect than greed, when levels of fear are extremely low the effect of greed becomes apparent, which is why the VIX can never go to zero.

For a detailed discussion of current option performance, see the in-depth analysis that follows.

Weekly 3-Step Options Analysis: 

On the chart of “Stocks and Options at a Glance”, option strategies are broken down into 3 basic categories: A, B and C. Following is a detailed 3-step analysis of the performance of each of those categories.

STEP 1: Are the Bulls in Control of the Market?

The performance of Covered Calls and Naked Puts (Category A+ trades) 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

Covered Call trading did not experience a single loss in 2013, and the streak endures so far in 2014, continuing a streak of nearly lossless trading extending all the way back to late 2011. That means the Bulls have been in control since late 2011 and remain in control here in 2014.

As long as the S&P remains above 1769 over the upcoming week, Covered Call trading (and Naked Put trading) will remain profitable, indicating that the Bulls retain control of the longer-term trend. Below S&P 1769 this week, Covered Calls and Naked Puts will not be profitable, and since such trades only produce losses in a Bear market, it would suggest the Bears were in control.

he 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.

•           “If stock prices have been falling long enough to have caused extremely high implied volatility, as measured by indicators such as the VIX, and I can collect enough of a premium on a Covered Call or Naked Put to earn a profit even when stock prices fall drastically, the Bears have lost control.” It’s probably very near the end of a Bear market.

STEP 2: How Strong are the Bulls?

The performance of Long Calls and Married Puts (Category B+ trades) 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

Long Call trading became unprofitable this past March, Those losses intensified during April and early May before reverting back to profits in recent weeks. Losses for Long Calls are a sign of weakness for a Bull market. Such weakness can be dangerous because it lowers the perceived reward potential for stock owners, which makes stocks less attractive, in turn lowering the price stock sellers are able to obtain from buyers.

As long as the S&P closes the upcoming week above 1913, Long Calls (and Married Puts) will remain profitable, suggesting the Bulls retain confidence and strength. Below 1913, Long Calls and Married Puts will not be profitable, which would suggest a significant shift in sentiment, notably a loss of confidence by the Bulls. Confidence and strength show up as a “buy the dip” mentality, while a lack of confidence and strength produces a “sell the rip” sentiment that tends to set recent highs as brick-wall resistance, since each test of that high is perceived as a rip to be sold.

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, they are also 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 or Bears Overstepped their Authority?

The performance of Long Straddles and Strangles (Category C+ trades) 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

The LSSI currently stands at -1.8%, which is normal, and indicative of a market that is neither in imminent need of correction nor in need of a major breakout from the trading range of the last few months. Positive values for the LSSI represent profits for Long Straddle option trades. Profits represent an unusual condition for Long Straddle trading, one of three unusual conditions that warrant attention.

The 3 unusual conditions for a Long Straddle or Long Strangle trade are:

  • Any profit
  • Excessive profit (>4% per 4 months)
  • Excessive loss (>6% per 4 months)

Long Straddle trading (and Long Strangle trading) will not be profitable during the upcoming week unless the S&P closes above 1985. Values above S&P 1985 would suggest a significant shift in sentiment, back to a euphoric “lottery fever” type of mentality that tends to lead to a rally for stock prices.

Excessive Long Straddle trading profits (more than 4%) will not occur unless the S&P exceeds 2059 this week, which would suggest absurdity, or out-of-control “lottery fever” and widespread acceptance that stock prices have risen too far too fast for the rate to be sustainable, thus needing to correct in order to return to sustainability.

Excessive Long Straddle losses (more than 6%) will not occur unless the S&P falls to 1875 this week. Since excessive losses tend to coincide with a desire for traders to make stock prices break out, either higher or lower than the boundaries of their recent range, a break higher from 1875 would be a major bullish “buy the dip” signal, while a break below 1875 would signal a full-fledged Bull market correction was underway.

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 just been moving quickly, but at a rate that is surprisingly fast.” Profits warrant concern that a Bull market may be becoming over-bought or a Bear market may be becoming over-sold, 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 trend has been ridiculous and unsustainable.” No matter how much strength the Bulls or Bears have, they have pushed the market too far, too fast, and it needs to correct, at least temporarily.

•           “If I pay both premiums and suffer a loss of more than 6%, then the market has become remarkably trendless and range bound.” The stalemate between the Bulls and Bears has gone on far too long, and the market needs to break out of its current price range, either to a higher range or a lower one.

*Option position returns are extrapolated from historical data deemed reliable, but which cannot be guaranteed accurate. Not all strike prices and expiration dates may be available for trading, so actual returns may differ slightly from those calculated above.

The preceding is a post by Christopher Ebert, co-author of the popular option trading book “Show Me Your Options!” He uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. Questions about constructing a specific option trade, or option trading in general, may be entered in the comment section below, or emailed to OptionScientist@zentrader.ca

twitter

 Related Options Posts:

Beware – Options Rank S&P Rally C-Minus

How To Trade Without Watching The News

Forming Darvas Boxes With Stock Options

 

Leave a Reply

You must be logged in to post a comment.