Jeff Pierce's  Instablog

By Chris Ebert

As with all technical indicators, the Option Indices are intended to be tools to help traders plan future trading in a manner that increases the probability of a profit. Last week, it was reported here that the Long Call/Married Put Index (LCMPI) was in danger of reaching a level that would indicate that the current bull market had ended. As of May 10, the Index had not reached that level, although it was very close. It is even closer this week.

The LCMPI measures the strength of a bull market. When long calls or married puts with terms of 112 days, 28 days, and 7 days all become unprofitable, it is a strong indication that a bull market has ended. The LCMPI has not been in negative territory since early December 2011, so a change in the Index would mark a significant change in the sentiment of the market. When emotions change, new price patterns often emerge.

As of May 10, the requirement for the LCMPI to turn negative was that the S&P 500 remained below 1349. Because the Index progresses with changes in market prices as well as volatility, the bar has been raised slightly this week; the SPX now needs to remain above 1369 in order to prevent a change in the LCMPI. Given the current trading level of 1340, that is a very real possibility.

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When the LCMPI indicates that a bull market has lost its strength, traders should take note. In order to eliminate false signals, the Index requires that all three periods verify the same market conditions in order for a switch between bullish and non-bullish. Without a sudden, unforeseen rally by week's end, the LCMPI will be tripped to non-bullish for the first time in about five months. Once it is tripped, it is not likely that it will return to a bullish indicator for several weeks, or possibly months. The requirement, that the Index changes only when all three measurement periods verify the same conditions, is meant to shield traders from noise. A switch between bullish and non-bullish is a relatively rare and significant event for the LCMPI.

When the LCMPI is tripped to non-bullish, the implications to option traders buying long calls or married puts may be obvious; such trades will probably have very low odds of returning profits. However, such a change should also cause "buy-the-dips" stock traders to reconsider how effective that method will be if the bull market is truly over. For those participating in long-term investments such as retirement plans, a non-bullish LCMPI provides an opportunity to evaluate whether their portfolios, even those that buy the dips through dollar-cost-averaging, are allocated too heavily in stocks in a market that is no longer in a strong uptrend.

The other option indices, the CCNPI and LSSI, are also indicating changes in the emotions of traders and those updates will be available here later in the week.

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".

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