The Option Indices were designed several years ago as a means of analyzing the stock market. They do so in a unique manner that allows traders to use indicators that are more tangible and easier to understand than many of the traditional stock market indicators currently available.

The Indices have been, and continue to be, published regularly at zentrader.ca since 2012, including charts designed to help traders visualize the stock market. Today – a closer look at the construction of the chart of the Options Market Stages.

A Little Background on the Option Indices

To start, any chart that attempts to portray the stock market environment must be able to distinguish a Bull market (in which stock prices tend to rise) from a Bear market (in which stock prices tend to fall). Seems simple enough; but, there are numerous ways to define a Bull or a Bear market, so it can get complicated in a hurry.

The Option Indices provide a simple method for separating the Bulls from the Bears – something tangible – something ordinary – something most traders are aware of:  an option trade known as a Covered Call. Without ever trading a Covered Call, any trader can use the outcome of a Covered Call to determine whether the current stock market is a Bull or a Bear.

It all comes down to this: The premium on a Covered Call depends on the collective sentiment of traders around the world. When stock prices are steady or rising, the premium tends to be quite low. When stock prices are choppy, volatile, or falling, the premium tends to increase. Option traders are free to set the premium as high as they like, in order to protect themselves from losses. Therefore, it is only when those premiums prove insufficient that the market can be considered Bearish.

For example:

• If a stock is trading at $100 and the premium on a $100-strike Call option is $5 per share, a decline in the stock price to $95 would not be considered Bearish because a Covered Call (opened by buying 100 shares of the stock at $100 per share and simultaneously selling one $100-strike Call option at $5 per share) would not suffer a loss.
• If the same stock is trading at $100 and the premium on a $100-strike Call option has risen to $10 per share because of turmoil in the market, a subsequent decline in the stock price below $90 would be considered Bearish because the Covered Call trader would suffer a loss.The Covered Call trader made a mistake, and did not ask for enough of a premium. The fact that the Covered Call trader did not correctly anticipate the magnitude of the decrease in the stock price is what makes this move Bearish, while the ability to correctly anticipate the move made the previous example Bullish.

While the above examples apply to individual stocks, a Covered Call opened on a broad array of stocks, such as the S&P 500, can determine whether the market as a whole is Bullish or Bearish. One of the common products that tracks the S&P 500 is the SPDR S&P 500 ETF Trust (NYSEARCA:SPY), or SPY for short. Therefore, if a Covered Call on SPY results in a profit at expiration, the market as a whole may be considered Bullish; a loss may be considered Bearish. The dividing line between Bullish and Bearish would be the point at which a Covered Call would break even.

Creating the Chart

To form a graph, all that is necessary is to plot the points, each week, at which a Covered Call would break even. For convenience, the strike price of the Call is always at-the-money when opened, and the expiration date is always 4 months prior.

For example, to plot the break-even point on June 15, one would use the price of SPY from 4 months earlier, on February 15, and use the premium of an at-the-money Call, on February 15, that expired on June 15, to determine the level of SPY on June 15 which would result in a break-even trade for a Covered Call at expiration.

If SPY was $200 on February 15 and the premium for a $200-strike Call that expired June 15 was $20, the break-even point on June 15 would be $200 - $20 = $180. Thus, if SPY was above $180 on June 15, that would indicate a Bull market, below $180 would indicate a Bear market. Using the same process to determine the break-even point for every week for an entire year will result in a chart like the one below. The red line separates a Bull market above from a Bear market below.

Vertical scale represents the S&P 500, typically 10 times the share price of SPY. If SPY is trading at $200, the S&P is likely near 2000.

O.K., we have divided Bull from Bear. Now it’s time to divide a strong Bull market from a weak Bull market. For this, the same process is used as with Covered Calls, except this time Long Calls are used. Long calls only profit in a strong Bull Market and are losers in a weak Bull market. The yellow line separates a strong Bull market above from a weak Bull market below.

Next, we divide a super-strong Bull market from an ordinary strong Bull Market. This requires the use of Long Straddle trade performance. Long Straddles only profit in a super-strong Bull market. The blue line separates a super-strong Bull market above from an ordinary strong Bull market below.

Next, we divide an unsustainably-strong Bull market from a sustainable super-strong Bull Market. Using the same process as above, we find the point at which Straddle trades on SPY result in an uncommonly-high profit of 4%. Long Straddles only return profits of more than 4% when a Bull market has caused stock prices to rise too far too fast. The green line separates an unsustainably-strong Bull market above, from a sustainably-strong Bull market below.

Lastly, we divide a trendless, range-bound Bull market from one with a trend. The lack of a trend often indicates a market that may soon make a major move in either direction, by breaking out of its recent trading range. During a pullback in stock prices, a trendless market often precedes a bounce higher and an end to the pullback, or else a move lower that tests the final support of a Bull market – the division between Bulls and Bears – the red line. Using the same process as above, we calculate the point at which a Long Straddle would experience an uncommonly high loss of -6%. Long Straddles only return losses of 6% or more when the market has been trendless for several months. The orange line, marking the points of no trend, separates an uptrend above, from a downtrend below.

Now, we have a chart of the Options Market Stages, spread over a period of 12 months.

• Stage 1 exists between the green and blue lines
• Stage 2 exists between the blue and yellow lines
• Stage 3 exists between the yellow and orange lines
• Stage 4 exists between the orange and red lines
• Below the red line is Bear Market Stage 5

It is quite simple to plot the S&P 500 over the chart of the Options Market Stages. Doing so gives us a visual snapshot of where the stock market has been, where it is today, and several scenarios of where it will be in the future.

Following is a complete description of all of the Options Market Stages, in which each stock market environment correlates with a Stage on the chart generated above.

The preceding is a post by Christopher Ebert, co-author of the popular option trading book “Show Me Your Options!” He uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. Questions about constructing a specific option trade, or option trading in general, may be entered in the comment section below, or emailed to OptionScientist@zentrader.ca