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Option Indices Don’t Just React,They Predict

March 20th, 2013
in contributors, syndication

by Chris Ebert, Zentrader

Zentrader readers have overwhelmingly expressed a need for an expanded view of the option indices. Today, the view has been expanded to include values going back to January 1, 2004. The option indices are unique to this site and are published here weekly, normally as a two-year snapshot.

Options are very similar to insurance policies. Every trader is free to buy insurance or to sell insurance. The premium for these “insurance policies” is determined by the amount of risk involved; and the risk is determined by the current condition of the stock market as well as predictions about its future condition.

Just like the insurance business, option trading is an art, not a science. No matter how much risk-analysis goes into the process of setting premiums, there are times when insurance companies collect premiums that exceed the claims for losses. Other times, catastrophes can strike and cause the claims to exceed the premiums. Option trading is no different.

Follow up:

As efficient as the options market is at analyzing risk, the premiums will at times benefit option sellers, and other times option buyers. This inefficiency – the inability of the options market to perfectly set premiums so that neither the buyer or seller benefits – can provide all traders with a whole new way of viewing the stock market.

Let’s start with the simple strategy of covered call trading. The covered call trader buys a stock or ETF (exchange traded fund) and then sells a call option. If the ETF is a broad-based fund such as the SPDR S&P 500 Trust (SPY) then the covered call trader is essentially selling an insurance policy that covers the risk of loss in the event the S&P 500 suffers damage, such as from a sell-off or a market crash. The covered call trader collects a premium, but is on the hook for any losses if the S&P experiences a decline.

When skies are blue and the market is sailing smoothly, premiums on call options are generally low. When there is not much risk of a crash, a covered call trader can collect a smaller premium and still manage to earn a profit. When the market is volatile and stock prices are falling or making wild swings, covered call traders demand higher premiums to cover their risk, because as always they are on the hook for any losses if stock prices fall. Despite the higher premiums, the options market is not efficient enough to ensure that covered call traders will always collect premiums that are sufficient to offset all losses. Covered call traders can and do lose money at times. When they do lose, it can be an important signal to all traders, whether they trade options or not.

  • COVERED CALL/NAKED PUT INDEX

The Covered Call/Naked Put Index (CCNPI) measures the profitability of covered call trading using at-the-money options opened 112 days before expiration on the S&P 500. If a large, profitable insurance company suddenly began to experience more liability in claims than it could collect in premiums, that would be newsworthy. It would indicate that something had changed drastically in the insurance market. When the CCNPI indicates that covered call trading has suddenly become unprofitable, especially after an extended period of profitability, it is also newsworthy. It means the stock market has changed drastically.

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The above chart of the CCNPI has been highlighted to show periods in which an extended period of profitable covered call trading was followed by unprofitability. The change from profitability to unprofitability often precedes an extended period of declining prices in the S&P. The change from unprofitability back to profits is often a sign that the storm has passed. A textbook example can be seen in the switch to unprofitability in July 2008 which preceded the U.S. economic collapse, and the switch back to profitability in March 2009 which preceded the bull market run of 2009-2010.

One can see from the chart that the CCNPI does have predictive abilities, but there are also significant limitations. For example, in 2008 it did not signal the presence of a bear market until the S&P had already fallen 10% or more off of its recent highs. So while it may be theoretically possible to profit by simply going long when the CCNPI is positive and selling the instant it turns negative, the fact is that a significant amount of those profits may be lost while waiting for the CCNPI to react during a downturn.

  • LONG CALL/MARRIED PUT INDEX

Long call trading provides additional signals that may help a trader get out of the market earlier in a downturn than would be possible with the CCNPI alone. The Long Call/Married Put Index (LCMPI) measures the profitability of at-the-money long calls on the S&P 500 opened 112 days prior to expiration. When long call trading is profitable, it means the market is not just bullish, but strongly bullish. Conversely, when long call trading suddenly turns unprofitable it is often a sign of weakness. Long call trading, because it requires the payment of a premium, can result in losses, even in a bull market, if stock prices do not rise fast enough to offset the premium paid.

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In the above chart, periods in which long call trading were unprofitable have been highlighted. When the LCMPI is negative it is a signal of weakness. One could argue that it may be possible to profit in the long term by only being long when the LCMPI is positive. However, that would likely result in missing a significant portion of the beginning of each uptrend.

Comparing the CCNPI to the LCMPI it can be seen that he CCNPI is more accurate at signaling the beginning of an uptrend than the LCMPI, while the LCMPI is more sensitive to signaling the beginning of a downtrend. One logical use of the two indices would be to use the CCNPI as a buy signal and use the LCMPI as a signal to tighten stops, lighten up long positions, protect longs with put options, or possibly prepare to go short.

No matter which technical indicators a trader employs, they will never guarantee a profitable outcome. Even when the CCNPI and LCMPI are combined, there will be times that the market is unpredictable. While unpredictability can never be totally eliminated, a third type of option strategy can help somewhat.

  • LONG STRADDLE/STRANGLE INDEX

The Long Straddle/Strangle Index (LSSI) measures the profitability of a combination of a long call and a long put, both purchased at-the-money 112 days before expiration on the S&P 500. Long straddles are expensive trades to open because they require the payment of two premiums. So while a strong bull market can result in profits for long call trading, it takes a super-strong bull market to make long straddle trading profitable.

A super-strong bull market is not a common occurrence. In fact it is so uncommon that a positive LSSI is often indicative of a market that has come too far too fast. When the LSSI exceeds 4% it is often a signal that the market is about to make a correction. This is also true in downturns. It takes a super-strong bear market to cause long straddles to return profits, especially profits that exceed 4%. In these rare instances, a market with prices in free-fall is often met with a corrective rally, at least in the short term.

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An LSSI of over 4% is therefore a good predictor of an upcoming pullback after a recent strong uptrend, or an upcoming rally after a recent downturn. So regardless of whether the CCNPI and LCMPI both suggest it is a good time to be long, the LSSI can suggest a good time to protect a portfolio from a correction. In a bull market, buying short-term protective puts when the LSSI is elevated is one way to leave the profit potential of stocks in place, while allowing the puts to benefit from any correction that ensues. In a bear market, buying short-term calls when the LSSI is elevated is a way to profit from a temporary rally without covering all the shorts. In the event such a rally proves to be more permanent than temporary, the calls will prevent excessive losses.

The LSSI is not just an indicator of corrections. It can also signal an upcoming breakout, in which stock prices begin to trade in an entirely new range from that of the previous weeks or months. A level of the LSSI below -6% means that straddles are suffering unusually high losses. Usually this happens because the premiums were high to begin with, such as during a period of high volatility, but that the market failed to experience a major sell-off. In other words, the market was expecting a crash and the crash never happened.

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There are only two things that can happen when a sell-off fails to occur as expected. Traders find a new sense of confidence and send stocks to a much higher trading range, or traders get tired of waiting, sell their stocks, and actually cause the same sell-off they initially feared. As can be seen on the chart above, the last three times the LSSI fell below -6% (November 2011, June 2012 and December 2012) stocks broke out to a higher trading range within a few weeks. But in July 2011 the LSSI also exceeded the -6% limit and stocks broke out into a much lower trading range the following month.

*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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