By Chris Ebert
Given the importance of emotions in trading, it may come as surprise that widespread measurement of these seemingly intangible aspects of the stock market is a relatively new phenomenon. Fear indices such as the VIX, VXD and VXN, while commonplace today, were almost unheard of 20 years ago.
The VIX is a powerful technical indicator. Derived from the pure emotions of option traders, it differs from other types of analysis in that it represents how the market perceives the future. When the consensus of trader's emotions is justified, individual traders can benefit from a study of the VIX. However, there are many instances in which the market either becomes complacent - resulting in the volatility index giving a false sense of security, or becomes overly fearful - yielding an unjustified sense of impending doom.
Readers were alerted here on April 4 that the VIX was showing signs of complacency, and those who remained bullish at that time were advised of the attractiveness of relatively cheap insurance then available in the form of protective put options. Those who took that opportunity to protect their portfolios have since endured losses approaching 10% in the S&P and a nearly 1,000 point decline in the Dow, but have done so without giving up the gains of the earlier Bull Market of 2012.
In order to address the limitations of volatility indices such as the VIX, namely their tendencies to underestimate future volatility at market tops and overstate it at bottoms, three new option indices were recently introduced. The Covered Call/Naked Put Index (CCNPI), Long Call/Married Put Index (LCMPI), and Long Straddle/Strangle Index (LSSI) each measure changes in the emotions of traders. The most recent update of these indices indicated a major shift in sentiment. The implication of this shift is that protective put options no longer present the opportunity they offered several weeks ago. There is a correct time for every option strategy, and protective puts are no different in this regard.
So what is the best stock and option strategy now?
- Long Stocks - Now that the LCMPI has lost its bullish pattern, choosing the best performing stocks will become more important. Traders buying the actual shares or using options to create synthetic long positions can no longer rely on upward momentum of the broader market to support individual stocks. Almost everyone is a winner in a bull market, but only the best do well in a flat market or downtrend. Individual stocks showing strength in spite of the downturn are the most likely to profit when the trend eventually reverses.
- Protective Puts - From the change in the LCMPI, it appears that the time for new protective puts has passed; opening such trades now is equivalent to closing the barn door after the horse has escaped. However, those that were opened before the recent selloff have given traders a nice opportunity to wait out the current market in hopes of a rebound without taking on much additional downside risk.
- Long Puts - While selling puts has recently become unprofitable as indicated by the CCNPI, volatility has also limited the effectiveness of simply buying at-the-money puts. Although these trades do have the potential to be winners if the market crashes, the premiums are now too high to generate profits in most cases.
- Long Calls - The consistent poor performance of the LCMPI over periods from 7 to 112 days shows that at-the-money long calls are currently long shots. Even if the market does bounce back, the resulting decrease in volatility will greatly lower the profitability of these trades.
- Long Straddles or Strangles - Given the relatively high premiums compared to several weeks ago, long straddles and strangles, while they have shown recent gains, have historically not sustained such gains for periods exceeding a few weeks. The recent positive performance of the LSSI is a rare occurrence.
- Naked Calls - Although buying at-the-money calls has been a losing practice over the past several weeks and months, as indicated by the LCMPI, reversing the trade by selling naked calls involves considerable risk. As risky as these trades are, the risk can be minimized by choosing an appropriate strike price. It would take some outstanding news to propel the major market indices back up to the trading levels of early April or May. Even if Europe experiences some sort of financial miracle or U.S. jobless numbers suddenly plunge, the markets will likely experience resistance near the levels of the year-to-date highs of a few weeks ago. Selling near-term naked calls with strikes near those expected levels of resistance would not only take advantage of the increase in premiums caused by recent volatility, but would also benefit from the volatility crush that would occur if the market did rally back that high.
- Naked Puts - While the weakening CCNPI shows just how risky these trades can be when they are opened at-the-money, the volatility-inflated premiums now allow these trades to generate income even at strikes far out-of-the-money. Traders who remain bullish and would be willing to go long in the market at a level such as the 200-day moving average or a year-to-date low can sell naked puts at strikes near those apparent support levels. If the puts end up being assigned, the underlying shares would be purchased at the price the trader previously believed was desirable.
- Covered Calls - Given the recent poor performance of the CCNPI, at-the-money covered calls are not looking particularly attractive at the moment. Those that are out-of-the-money have fared even more poorly. As with naked puts, lowering the strike price of a near-term covered call to a level at which a long-term bullish trader would be willing to go long in the underlying shares is an effective method of generating income while buying the dips. If the calls are assigned, the trader keeps the time premium as income; if not, the result is a long position at the cost basis of the covered call. When used correctly, covered calls can work well in bull markets, range-bound markets and even moderate downturns. Being a sort of Triple Crown of option trades, I think I'll have another covered call.
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".