By Chris Ebert

Graphical representation of these option posts

Summary

Recent buying across the broad market represented by SPY has greatly improved the performance of some types of option trades. Covered calls and naked puts with terms ranging from 7 days to 112 days are again profitable. After a month-long losing streak encompassing the month of May, the return to profitability in June is an indication that traders are becoming less fearful. Long calls and married puts are mostly doing well, with only the longest term positions indicating a lack of strength. Long straddles and strangles are losing trades for all of the time periods measured, as is to be expected whenever market emotions are under control.

Bullish Indicators

The Covered Call/Naked Put Index (CCNPI) measures the performance of these trades when opened at-the-money over three different time frames. Because such option strategies generally only result in losses during a bear market, when prices fall more than enough to offset the premiums collected, profitability is usually an indication that bulls are in control. While these trades are not performing as well as earlier in the year, the return to profits for all three time periods is a sign of hope.

 

Bull Market Strength

The Long Call/Married Put Index (LCMPI) tracks these at-the-money option strategies to determine the strength of a bull market. When an uptrend becomes sufficiently strong, implied volatility often dips and the premium to open these trades becomes lower as well. The combination of lower premiums and rising prices causes long calls or married puts to become profitable whenever there is a strong bull market. Currently the 7-day and 28-day trades are showing strength, but the poor performance of the 112-day trade is weighing down the index. Although conditions are improving, the market is not yet showing the signs of strength that it was earlier in the year.

 

Justification of Fear

The Long Straddle/Strangle Index (LSSI) follows the performance of these option strategies to reveal whether or not trader’s emotions are in check. Straddles and strangles tend to be losing trades in a normally functioning market. The relatively high premium to open these option strategies requires the market to experience either an unexpected rally or selloff in order to generate a profit. When profits reach 5% or higher, emotions are out of control and fear is running the market. This week, measurements for all three time periods show losses, indicating a safe, well-controlled market.

 

All Index values are calculated relative to the S&P 500 using volatility data to extrapolate the theoretical performance over the given time periods. It is not possible to match the exact performances shown because the strike prices and expiration dates available in actual trading will always differ from those used in the calculations.

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”.

 Questions about these or any other option trades are encouraged. Please enter them in the comment section below, or email them to optionscientist@zentrader.ca.

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2 Responses to “Options Show Improvement Amid Weakness”

  1. jeff pierce Says:

    Is the danger zone on the LSSI an indication of a market that is going to reverse and head lower?

  2. chris Says:

    Jeff,

    I would say that is usually true in an uptrend, where the danger zone is reached because the market has come too far, too fast. Using an RSI indicator for verification, the LSSI can be a signal that an overbought market is ready for a correction.

    The opposite would be true when a wild sell-off pushes the LSSI into the danger zone. In that case it could be a signal that the market is ready to bounce, often a dead-cat bounce.

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