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Options: Cause For Concern Over Mid-1500s S&P

March 5th, 2013
in contributors, syndication

by Chris Ebert, Zentrader

For those keeping score – Over the past 66 weeks, covered call trading on the S&P 500 has returned a profit 64 times. That’s no surprise. The only time that covered calls are unprofitable is in a bear market, when stock prices fall so fast that the premium received on a covered call is too small to make up for the loss on the stock.

There have been some significant sell-offs over the past 66 weeks, but it takes more than a sell-off to create a bear market. Sell-offs, corrections, pullbacks, consolidations, whatever one wants to call them, are often a sign of a healthy bull market. No matter how great the pullback, as long as covered call trading remains profitable the argument can be made that it is not a bear market, just a bull market that is getting prepared for the next leg up.

Follow up:

The Covered Call/Naked Put Index (CCNPI) is published here each week, and tracks the profitability of covered call trading. Because covered call profitability is directly linked to the existence of a bull market, the CCNPI is an effective indicator of bullishness or bearishness among the broad array of stocks that make up the S&P 500. This past week saw profits for covered call trading, so the CCNPI remained positive, and that indicates continued bullishness among traders. But because all bull markets must eventually come to an end, the CCNPI by itself presents too narrow a view of the market. That is where the other option indexes become useful.

The Covered Call/Naked Put Index (CCNPI) is actually one of three option indices, each with its own insight into the stock market. Together with the Long Call/Married Put Index (LCMPI) and the Long Straddle/Strangle Index (LSSI) a complete picture of the current market conditions appears. The 3-step process is as follows:

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 an extended 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 were both very near to returning profits. Profitability does not necessarily indicate that a market correction is imminent, but it is an important warning sign.

Profitability is a rare occurrence for long straddles or long strangles, so it is a good indication that the condition of the market is one that is rare as well. Profitability can sometimes signal that the market is topping out, while excessive profitability (in excess of 4%) is almost a sure sign that the market has reached a top and is about to correct. The 4% level has not been reached yet, but it wouldn’t take much now. A couple of triple digit gain days for the Dow or the mid-1500s on the S&P is all it would take to push the LSSI over 4%. If that happens, look out below! 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

Conclusion

It is still possible for prices to move a little higher without the LSSI signaling that the market is “Due for a Correction”. It is a bull market, as shown by the CCNPI. In fact, it’s a strong bull market, as shown by the LCMPI. Higher prices are what bull markets are about, so they would not be surprising now. But at the same time, higher prices could easily push the LSSI to signal a correction now. If the S&P gets into the mid-1500s or the Dow gets to the mid-14,000s over the next week or so, that should be a flashing red light to all traders to be prepared for the possibility of a correction. But the LSSI has already put up a warning sign, so waiting to see the flashing red light does carry some risk.

*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.









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