By Chris Ebert
Option Index Summary
Imagine, for a moment, that there was a magical trade that would provide a return of 4% or more in just 3 months' time. That's an annual rate of 12% or more. Should I be interested?
Now, imagine that this magical trade only required about 10% of a trading account be invested, leaving the remaining 90% to either earn interest or to be invested elsewhere. Should I begin to be skeptical?
Now, suppose that this magical trade did not require any knowledge of the stock market, of bulls or bears, or any inkling at all as to whether stock prices were headed up or down. I would be wasting my time by reading any further, right?
The fact is that such returns are absurd. The ability to open a cop-out trade, one that basically says "I have no idea which way the stock market is headed", and to earn a 4% profit on that trade in 3 months, is something magical. It defies reality. Really! It is one thing to trade the market based upon a prediction of an uptrend or a downtrend and earn a profit. But to make no prediction at all and earn a profit, that's quite an accomplishment.
Despite the absurdity, there is currently a trade that meets the above criteria. That trade is known as a Long Straddle. And it is so simple, almost anyone can do it. It is just a combination of two option purchases; a call option that returns profits if stock prices go up, and a put option that returns profits if stock prices go down.
The specific long straddle referenced here is one that:
- Is opened three months prior to expiration (112 days)
- Uses options on a broad-market ETF such as the SPDR S&P500 Trust (NYSEARCA:SPY)
- Is opened At-The-Money (the strike price of both options is the same as the share price of SPY on the day the options are purchased)
The Long Straddle/Strangle Index (LSSI) measures the profit and loss of the above trades. This week, the 112-day LSSI stands at +4.2%, which means that a long straddle on SPY would have returned a 4.2% profit when it expired this week. That's a nice profit for any trade, let alone a cop-out trade. For a cop-out trade, it truly is absurd.
Traders often encounter those who say they are permanently avoiding the stock market because they have no idea which way it is going. Traders themselves occasionally move to the sidelines during times of uncertainty. Avoiding stocks is generally a good way to avoid risk. But avoiding risk comes at a price - lower risk usually means lower rewards. That is a trade-off that most people are willing to accept.
Often times, someone might say "I moved my funds to a money market account because I have no idea which way this market is going next. I'm not earning much interest, but at least I won't lose anything". It would be a notably rare occurrence to hear someone say "I bought a straddle because I have no idea where this market is going next." There's a reason for that; a very good reason. Straddles rarely produce profits. Rarer still is a profit that exceeds 4% in 3 months. If straddles were a viable alternative during times of uncertainty, there would be no need for bonds, or money market accounts, or even cash itself. Everybody would be buying straddles. The recent 4% profitability of straddles is abnormal, as they rarely produce profits at all, often produce losses, and occasionally produce large losses.
We are now at a point where straddles on the S&P 500 are producing profits - nice profits; over 4% in 3 months, or an annual rate of over 12%. Obviously, such profits cannot continue for very long. If they did, folks with funds parked in money market accounts would start to get jealous. Stock traders could stop analyzing charts and company fundamentals, open up some straddles, and spend the next 3 months relaxing on a tropical beach. Mutual fund managers would likely find themselves in the unemployment line. Trading isn't worth the effort when it's possible to earn 4% in 3 months without trading.
When the Long Straddle/Strangle Index (LSSI) exceeds 4%, as it did this week, it can serve as an important warning to traders that the current market condition is unsustainable. The stock market is not in the habit of giving away free tropical vacations!
So what happens next? The market will correct, as it does every time the LSSI exceeds 4%. The bulls have simply overstepped their authority and pushed prices too high, too fast. But in order to correct, it first needs to run out of buyers.
- Many bears who sold stocks short are currently buying to cover their shorts, but these buyers will eventually dwindle in numbers as the covering process becomes complete.
- Buy-and-holders may be enticed to re-allocate towards a higher percentage of equities now, but once they reach 100% allocation their influence will diminish.
- First-time buyers may help push prices higher, but there are only so many born each day.
- Returning buyers who were previously pushed away by recessions and volatility are a limited resource - when they're gone, they're gone.
So, while the LSSI currently indicates that the market is "Due for a Correction" the market can potentially move much higher, initially, at least until it runs out of buyers. Typically, the market will run out of buyers within a few weeks of the time the LSSI reaches 4%. There are good reasons to be a buyer now, and the two other option indexes show why. The Covered Call/Naked Put Index (CCNPI) is currently bullish, and the Long Call/Married Put Index (LCMPI) shows bullish strength. But the LSSI shows that there are also good reasons to be prepared for an upcoming correction. A complete picture of the market becomes clear by following the 3-step analysis 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.
This week, covered call trading and naked put trading were both profitable, as they have been for anextended 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.
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.
This week, long straddle trading and long strangle trading reached rare and absurd levels of profitability. Profitability in and of itself is a signal that the market is doing something strange. But this week's 4.2% profit is over the top, and simply unsustainable. The LSSI is now a warning sign flashing "CORRECTION AHEAD!"
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. Either way, 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
Somebody has to be willing to buy a stock in order for a seller to sell it. With prices going higher by the day, buyers are currently being drawn to the market in numbers more than sufficient to allow sellers to continue to sell at higher and higher prices. That's how a bull market works, and this is definitely a bull market - a strong bull market. But the bulls have pushed prices too far, too fast. When the LSSI exceeds 4%, as it did this past week, it signals that the pace of the number of buyers entering the market is insufficient to continue to support the pace of the uptrend in stock prices. No matter how strong a bull market is, it can not continue if it runs out of buyers.
Like a car running low on gasoline, a bull market can continue speeding up, right up to the point where it runs totally empty of buyers. The LSSI is the market's gas gauge, and it is indicating that now would be a prudent time to take a break. The market as a whole is free to ignore the warning and continue to push stocks higher until there are no more buyers. The market may also heed the warning, and take a break from the uptrend prior to exhausting the supply of buyers. The market is free to do what it wants without consequence, because the market as a whole will continue to exist whether it corrects now or waits till later. But individual traders who ignore the LSSI do so at their own risk.
Unlike the semi-permanent correction doomsayers that cry wolf every time the stock market shows any sort of sustained uptrend, the LSSI was designed to avoid excessive noise and only signal a correction when something major is likely to occur in the next few weeks, something like a 100 point decline in the S&P or a 1000 point drop in the Dow, lasting for at least several weeks. This past week marks the first time since March 23, 2012 that the LSSI has indicated a market that is due for a correction, and at that time the S&P almost immediately climbed into the 1400s, only to fall below the 1300 mark a few weeks later.
*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!"