By Chris Ebert
Perhaps there is no better way of measuring the health of the stock market than to check in with our three good option trading buddies: Mr. Income, Mr. Permabull and Mr. Gamble.
Mr. Income is a conservative fellow. He buys stocks and sells Covered Call options against those stocks to create a source of income. Each Covered Call option has a price (the price is generally called the premium of the option) and Mr. Income puts that premium in his pocket the day he sells the option.
It is quite similar to collecting a dividend, except that Mr. Income is making his own dividends. The only way he can end up with a loss is if his stock positions decline by a greater amount than the premiums he collects. As long as his income outweighs his losses he’s a happy option trader.
Mr. Permabull is not nearly as conservative as Mr. Income. He likes Bull markets and Bull markets only. He wants nothing to do with downturns, pullbacks, corrections, Bear markets or the like. When stock prices are going up, he buys what are known as Long Call options. When stock prices are going sideways he buys Long Call options; and when stock prices are falling he buys Long Call options.
In each scenario he pays a premium for the option and as long as stock prices subsequently climb he can earn a profit; as such, he is the ultimate buy-the-dip opportunist. The only way he can suffer a loss is if stock prices do not rise sufficiently to offset the option premium he initially doled out. As long as the Bulls are in control and are showing their strength, he’s content.
Mr. Gamble likes to bet on the stock market. He doesn’t care whether stock prices are going up or going down. All he cares about is whether stock prices are making some moves; and the bigger the move the better. He opens option trades known as Long Straddle options. A Long Straddle is nothing complicated, just a combination of a Long Call option and a Long Put option.
Whereas Mr. Permabull only pays a single premium for each Long Call option, Mr. Gamble pays two such premiums, one for the Call option and one for the Put option. The two premiums combined is a rather large amount, so Mr. Gamble needs a rather large profit on his stocks in order to offset the initial premium he paid for the options. The only way he can suffer a loss is if stock prices do not make surprisingly large moves in either direction. Whenever there’s a huge change in stock prices he collects on his bets.
For consistency, one can assume that all three traders prefer using a similar type of option – one opened using an at-the-money strike price and an expiration that is 4-months (16-weeks) away. Again, for consistency, it can be assumed that each trader only trades options on an Exchange Traded Fund (ETF), and that the fund they each prefer is $SPY (NYSEARCA:SPY).
That particular fund essentially matches the performance of the S&P 500 stock index. Thus, whatever the health of the broad basket of five-hundred stocks that makes up the S&P 500 index, Mr. Income, Mr. Permabull and Mr. Gamble will exhibit profits or losses that correlate with that very health. Or, to look at it another way, whatever their profits and losses may be, they will reveal the health of the S&P 500.
Covered Call Trading
Taking a look at Mr. Income, he opened his Covered Call options back on October 16, 2015. That is 4-months ago or 16-weeks to be precise. Back then the S&P had started to recover from its August massacre. The S&P 500 stood at 2033. The $SPY stood at $203 per share ($SPY share price is generally 1/10 of the S&P 500 value); and Mr. Income collected a premium of $7 per share when he sold his Covered Calls.
What is the only way Mr. Income can suffer a loss? If the share price declines by a greater amount than the premium he collects. Thus, if the share price declined more than $7 by the time the options expired this past Friday, he will have suffered a loss.
Indeed that is exactly what happened. The S&P 500 stood at 1880 this past Friday. The $SPY share price stood at $188. That is a decline of $15 since Mr. Income opened his Covered Calls back in October. So, even though he stuck $7 in his pocket when he sold the Covered Calls, he is still sitting on a net loss. He lost $15 on the shares but earned $7 in income, so he has a net loss of $8 per share.
It can be inferred from Mr. Income’s predicament that the current environment for the S&P 500 is not conducive to income-production. Anyone digging deeper into Mr. Income’s performance will find that he rarely suffers a loss outside of a Bear market. Therefore, one may conclude from his recent losses that the current S&P 500 is likely in the midst of a Bear market.
Long Call Trading
If it truly is a Bear market right now, then it would be expected that Mr. Permabull is doing poorly as well. Indeed he is. Of course, Mr. Permabull does poorly whenever there is an absence of bullish strength, even in a Bull market. But it pays to take a look at Mr. Permabull’s performance anyway, to see if there any clues that would confirm the pr4esence of a Bear market.
The only way Mr. Permabull can suffer a loss is if stock prices do not rise sufficiently to offset the option premium he initially doled out. Back on October 16 he doled out $7 per share to buy Long Call options on $SPY. At that time $SPY was trading at $203 per share. Today it is trading at $188. All the options he bought are now completely worthless (they only have value if $SPY is trading above $203). So, Mr. Permabull suffers a loss of $7 per share.
The reason Mr. Permabull’s Call options are worthless is that they gave him the right to buy shares of $SPY at $203 per share. What good is that right if he can buy $SPY on the open market for $188 per share? Nothing, hence those particular Call options not being worth the paper they are printed on. Whatever value they had back in October has vanished.
It is interesting to note the interaction between the two traders, since it is very rare for Mr. Permabull to outperform Mr. Income. A look at historical performance shows that such outperformance only occurs in two environments: roaring Bull markets and harsh Bear markets. Since the current market is certainly not a roaring Bull one, it can be inferred from Mr. Permabull’s outperformance of Mr. Income that the current environment must be quite bearish; some would call it harsh.
Long Straddle Trading
Although the two traders suggest this is currently a Bear market, the severity of the bearishness becomes evident only when looking at the third trader, Mr. Gamble.
Remember, Mr. Gamble only places bets. He does not care whether stock prices go up or down. All he cares about is whether stock prices make a move. That’s because the only way he can suffer a loss is if stock prices do not make a surprisingly large move. Any unusually large move in stock prices, regardless of the direction of the move, gives him a profit.
When Mr. Gamble opened his Long Straddle option trade back on October 16, the S&P was at 2033 and $SPY was trading at $203 per share. He bought a Call option at a cost of $7 and also a Put option at a cost of $7 for a total outlay of $14 per share. As always, he used an at-the-money strike price, meaning the strike price of the option was essentially the same as the trading price of $SPY shares at that time, $203.
When his Long Straddles expired this past weekend, Mr. Gamble was left with only one option that had any value – the Put option. Recall that the Call option would be worthless just like Mr. Permabull’s Call option was worthless because it would only have value if $SPY were trading above $203 per share. The right to buy $SPY shares at $203 per share is zero – the Call options are worthless today – because $SPY is available for $188 on the open market.
In fact, $SPY is trading considerably lower than $203 per share. The current price of $188 makes the Put options that Mr. Gamble owns incredibly valuable. Each Put option gives Mr. Gamble the right to sell $SPY at $203 per share. If he wanted to do so, he could buy shares on the open market for $188 and immediately exercise his right to sell those shares at $203. That’s an immediate $15 per share profit.
Before Mr. Gamble gets too excited at a $15 per share profit, he must subtract the original cost of the options he purchased. Since he spent $14 to buy the options back in October, his profit here in February is just $1 per share.
It’s not a great profit, but it’s a profit nonetheless. Mr. Gamble looks down his nose at both Mr. Income and Mr. Permabull as if to say “It looks as though I’m the only one of the three of us to be pulling in the profits these days.”
He is correct. He is truly the only one of the three to be making profits these days; and he did it not by carefully picking stocks nor by painstakingly analyzing corporate fundamentals nor by being a bullish trader or a bearish one. He did it by betting that stock prices would make a bigger than expected move. Simple as that – he placed a bet.
The fact that his bet paid off is important to note. It can be inferred that the S&P 500 has made a much larger move since he placed his bet than most traders were expecting. The S&P has moved more since October that the consensus expected. Since the move since October was clearly to the downside, it can be stated that the S&P 500 has declined more than most folks expected. The market is more bearish now than most expected in October.
Best Option Trade of 2016
To put it all together, Mr. Income’s losses suggest the current environment for the S&P 500 is a Bear market. Mr. Permabull’s losses suggest a lack of bullish strength in the market; bolstering the assertion from Mr. Income that the current market is bearish. Furthermore, the fact that Mr. Income lost more than Mr. Permabull signals that the current Bear market is getting quite harsh. Harsh Bear markets have historically favored Mr. Permabull over Mr. Income.
Finally, Mr. Gamble has started to profit again as of this past week. Since he only profits when the market makes surprising moves, the recent decline in stock prices absolutely must have come as a surprise to many market participants.
An interesting side note – Mr. Gamble only profits when Mr. Permabull outperforms Mr. income. Since Mr. Income relies solely on Covered Calls, the popularity of Covered Call trading should be apparent – they are always the best performing option trades of the three with one exception: when Mr. Gamble earns a profit, which is only when stock prices make a surprisingly large move. To word it another way, if Covered Calls are performing more poorly than Long Calls and Long Straddles, it’s almost certainly a Bear market.
As of this past week, of the specific* option trades mentioned, Covered Calls are the worst performing. That means the S&P 500 is probably in a Bear market at the moment.
The performance of Mr. Income, Mr. Permabull and Mr. Gamble together therefore suggest the current market is not just a Bear market but that many market participants have likely been taken by surprise by the emergence of a Bear market. Such surprise often occurs in the initial months of a Bear market; and it’s worth noting.
The element of surprise changes the way traders think and behave. They can become unpredictable individually. Indeed they can become unpredictable as a herd. Wild swings in prices, up one day down the next, reacting to news and economic developments in a manner that defies logic – that’s how surprise makes traders behave. This week, the three option traders are telling us to expect such behavior to occur unusually high frequently or with unusually high amplitude in the near future.
Another Way of Looking at It
All three of the option traders have been on the radar for many years. Their trades are recorded in three indexes.
- Income’s trades are recorded in the #CCNPI
The S&P 500 Covered Call/Naked Put Index
Mr. Income only suffers losses if stock prices decline by a greater amount than the premium he collects. Losses therefore indicate a Bear market. Profits signal a Bull market.
His loss this past week was approximately 4.2% of the share price of $SPY ($203) when he opened the trade back in October, or an $8 per share loss.
- Permabull’s trades are recorded in the #LCMPI
The S&P 500 Long Call/Married Put Index
Mr. Permabull only suffers losses if stock prices do not rise sufficiently to offset the premium he pays. Losses therefore suggest the absence of bullish strength (in other words, weakness). Profits suggest the presence of strength.
His loss this past week amounted to approximately 2.9% of the share price of $SPY ($203) when he opened the trade back in October, or a $7 per share loss.
- Gamble’s trades are recorded in the #LSSI
The S&P 500 Long Straddle/Strangle Index
Mr. Gamble only suffers losses if stock prices do not make a surprisingly large move in either direction. Losses suggest the absence of surprise among traders (things are normal). Profits signal the presence of surprise. Surprises are generally a normal part of the market cycle. Modest profits are therefore considered normal as well.
Uncommonly large losses or uncommonly large profits each suggest an abnormal an unsustainable market environment that tends to correct itself with a major price breakout or a major trend reversal, respectively.
His profit this past week was approximately 0.9% of the share price of $SPY ($203) when he opened the trade back in October, or a $1 per share profit.
It should be noted that just because Covered Calls are currently the worst performing trades of 2016 and Long Straddle trades are the best does not by any means suggest that the performance will remain that way heading into the remainder of 2016. In fact, to the contrary, changes in performance often happen quickly.
A look at any of the charts reveals how quickly any one poorly-performing strategy can shift to being an out-performer and vice versa. Additionally, the strategies above only cover a narrow slice of the options market due to the strike prices and expiration dates employed. Therefore the takeaway for a trader from the analysis should not be so much “Which option trade is best in 2016?” but instead, “What do these option trades say about the current health of the stock market in 2016?”
* Option strategies referenced above are analyzed for profit or loss on expiration day only and are opened using an at-the-money strike price, 4-months to expiration, using options traded on a broad-based ETF such as $SPY (NYSEARCA:SPY)
The preceding is a post by Christopher Ebert, Chief Options Strategist at Astrology Traders (which offers subscribers unique stock-trading perspectives and options education) and co-author of the popular option trading book “Show Me Your Options!” Chris 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
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