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Options Market Expressing Doubt Regarding Rally

By Chris Ebert

Option Index Summary

Despite the market nearing highs of the year this week, an analysis of stock options indicates that there is very little strength behind the recent uptrend. The Covered Call/Naked Put Index (CCNPI) continued to reveal bullish emotions this week, while the Long Call/Married Put Index (LCMPI) shows that traders are likely to continue to remain weak in their bullish convictions. The Long Straddle/Strangle Index (LSSI) returned to normal this week, after spending several weeks in overly-fearful territory, indicating that many traders are no longer expecting a market crash anytime soon.

Covered Call/Naked Put Index (CCNPI) - 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 as the 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:

  • When the market is in a downtrend - Implied volatility is usually higher than usual and the premiums received on these trades are also higher. Thus a positive 112-day CCNPI in a downtrend is often a bullish signal that marks the end of a downtrend.
  • In an uptrend - Implied volatility is generally low and the premiums received are lower as well. Thus a negative 112-day CCNPI often indicates the market has experienced more of a correction than would be expected in a bull market. A negative 112-day CCNPI in an uptrend is a bearish signal that may mark the end of an uptrend.

The 112-day CCNPI remained positive this week, and therefore is an indication of bullish emotions among traders.

Long Call/Married Put Index (LCMPI) - Weak (but improving)

Because buyers of at-the-money long calls or married puts must pay a premium, these trades will only result in profits in 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. 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. 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 is improving, but has remained negative for several weeks now, indicating that many traders are likely to continue to lack confidence in their bullishness.

Long Straddle/Strangle Index (LSSI) - Overly Fearful

Because buyers of straddles or strangles must pay two premiums, these trades will only result in a profit when the market moves up or down very strongly. When a long straddle or strangle returns a substantial profit it is an indication that traders were taken by surprise - they were complacent and underestimated the magnitude the market would move. Likewise, when the market is complacent, it can be profitable to buy a straddle or strangle (although whether complacency can be observed by means other than hindsight is debatable).

When a long straddle or strangle results is 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 tend 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 selloff, causing an increase in option premiums, but that such a selloff did not materialize. Thus a 112-day LSSI lower than -6% often precedes a breakout that either confirms trader's prior fears or completely puts those fears to rest.

The 112-day LSSI returned to normal this week. This index had been in the overly fearful zone last week, which was an indication that the S&P might have been ready to break out of its recent 1280-1420 range.

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".

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