By Chris Ebert

Option Index Summary

In the most recent Option Index Update the following conclusion was made:

From an option trading perspective, a big change in the market seems very probable now. It might not be tomorrow, it might not be next week. But the options are indicating 2013 will quickly reveal itself to be a much different trading environment than 2012. S&P 1400 and Dow 13,000 will soon become memories.

Not only is that statement still true this week, but the performance of certain option trades provides even more evidence in support of it.

The Long Straddle/Strangle Index (LSSI) tracks the performance at expiration of an option combination formed by buying a call option and a put option (a long straddle or long strangle), with a strike price at or near the share price of an S&P 500 ETF such as SPY (NYSEARCA:SPY). Of particular importance is the performance of those trades opened 112 days prior to expiration, because such trades tend to react quickly to changes in the market while smoothing out short-term changes that tend to create useless noise.

The 112-day LSSI dipped to -7.7% this week, well below the limit of -6% considered normal. This condition has occurred in the past, and each time it was followed by some violent moves.

  • July 15, 2011 -7.9% was followed by a wild August with the S&P down 200
  • Dec. 16, 2011 -10.5% was followed by the 2012 Bull Market
  • June 1, 2012 -7.9% was followed by a nearly 200 point gain in the S&P
  • Aug. 24, 2012 -6.7% was followed by a September rally
  • Nov. 16, 2012 -7.1% was followed by a late November rally

There is no way to predict with certainty which way the move will be the next time it occurs. There are still signs of bullishness in the Covered Call Naked Put Index (CCNPI). Covered call trading has remained consistently profitable recently. Not even the looming U.S. Fiscal Cliff hacautions had an effect on covered calls. Generally, when covered call trading is profitable it means the bulls are in control. The CCNPI shows continued bullishness this week.

The picture is not quite as rosy at was just a few months ago though. The Long Call/Married Put Index (LCMPI) has weakened considerably since then. Weakness is dangerous because it means that although the bulls are still in control at the moment, they could easily give up control, and they could do so quickly. If upcoming economic news satisfies the bulls, the market could potentially make a run at new highs. But, as has been the case for several weeks now, conditions are also ripe for a crash. In either case, up or down, the option indices are saying “Be prepared for something big, soon!

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 Trading

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 asthe 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).

LCMPI Dec 28 2012

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. Long periods of weakness tend to limit rallies as traders become more inclined to “sell on strength”, while also amplifying sell-offs as low-confidence bulls get “stopped out”. 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).

LSSI Dec 28 2012

Long Straddle/Strangle Index (LSSI) –   Now DUE FOR A BREAKOUT

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.

This week the LSSI stands at -7.7%, which is well beyond 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. This does not mean that a big move is a certainty, only that whatever move occurs in the upcoming weeks will be out of proportion to that catalyst that sparked it.

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!”

Related Options Posts:

Covered Call Trading Just Will Not Stop Winning

To Gauge Future Volatility – Try The LSSI Index

2012 Covered Call Trading – 50 Wins 2 Losses

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