Problems for Option Buyers

Ask anyone who has ever bought stock options, and you’ll likely hear at least one tale of regret. That’s because it’s possible to suffer a loss on stock options, not just when picking the wrong stock, but even when one is correct about the direction of the stock price.

It’s bad enough for a trader to pick the wrong stock and lose, but to pick the right stock and lose can be downright maddening. Without a thorough understanding of the behavior of stock options, it’s not just possible to lose money buying options on the right stock at the right time, it is actually very common.

It’s not that buying options is foolish; buying the right options at the right time can be an important part of a disciplined method of participation in the stock market. The problem for many traders is that they tend to view options as an asset, when in fact they are not assets in the traditional sense.

Options are more akin to insurance policies than they are to tangible assets like stocks. Thus, the difference between trading stocks and trading stock options is as different as the business of real-estate investing and the property-insurance business. They are entirely different creatures. Nonetheless, it behooves those involved in one business to pay attention to significant shifts in the other if the two are connected.

A doubling of fire insurance premiums, for example, should pique the interest of a real-estate salesperson, even though the salesperson may likely not be directly affected. Any significant change in the industry deserves attention.

The stock-market industry has just experienced one such rather significant shift. For the first time in several months, option buyers by and large are now experiencing uncommon gains. This shift has implications for anyone in the industry – any participant in the stock market – even those who are not directly involved with options.

It's a Buyer's Market

Buying options has suddenly become quite profitable. The list of profitable options, on the S&P 500 index as a whole*, includes a lot of option buyers this week. What that might mean for folks in the stock market is discussed in the analysis that follows:

• Selling Calls is profitable (Covered Calls)
• Selling Puts is profitable (Naked Puts)
• Buying Calls is profitable (Long Calls)
• Buying Puts is profitable (Married Puts)
• Buying both Calls and Puts is profitable (Long Straddles and Strangles)

Click on chart to enlarge

* All profits are calculated at expiration, as a percentage of the underlying SPY share price. SPY is an Exchange Traded Fund (ETF), the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) that closely tracks the performance of the S&P 500 stock index. All options are at-the-money (ATM) when-opened 4 months (112 days) to expiration.
EXAMPLE: If Long Call premium paid is $2 when SPY is trading at $200, the loss is 1% if the option expires worthless.

As noted above, the options business is like the insurance industry – it is intended to create income for the insurer. In this case the insurer is the option seller. Insurance is not intended to create income for the buyer; it is intended to protect the buyer. If the buyer does profit from the insurance, as happens occasionally with buyers of any insurance policy including stock options, it is an unintended consequence, not the primary intended purpose.

Stock Options Have Deductibles

Like most other forms of insurance, stock options are subject to deductibles. Each option clearly spells out what losses the seller is liable to cover and which losses the option buyer will not be reimbursed for, if a loss occurs. The deductible of an option is denoted by its moneyness which is commonly depicted by the strike price. The profit or loss for an option buyer, as with any insurance policy, can vary quite a bit depending on the deductible (the strike price of the option).

The generalization, that option buyers in the S&P 500 are currently profitable, may at first not seem too profound. After all, the profit depends on the deductible – the strike price. But, it is indeed profound considering the moneyness of today's profitable options, specifically at-the-money (ATM) options.

For example, a Call option with a strike price far below the current price of the stock is considered to be deep in-the-money (ITM). Such an option has a lot of moneyness. ITM options can be thought of as being insurance policies with very low deductibles. Call options with a strike price that is higher than the stock price are out-of-the-money (OTM) and have a very high deductible. Such an option has very low moneyness. As might be expected, the higher the deductible, the lower the premium.  Or to look at it another way, more moneyness = lower deductible = higher premium. ITM options always have much higher premiums than OTM options because ITM options have a lower deductible (the option seller has a larger obligation if the stock price moves in the direction being insured against).

Someone who sells a deep ITM Call is essentially selling insurance against an increase in the stock price, with little or no deductible. The buyer of that particular ITM Call option is buying protection against a rising stock price, again, as mentioned, with little or no deductible. In many types of insurance in which there is very little deductible, there is a propensity for abuse and fraud. Fraud, however,  implies deception and presumably there is no way for an option buyer to deceive a publicly-traded option seller. Each party, buyer and seller, enters the insurance contract fully aware of the risks. Thus, buyers of ITM options are technically not committing fraud, but they are certainly using options for a purpose other than what would be considered ordinary insurance. ITM option buyers enter a contract with a pre-meditated intention of filing a claim.

Abusing Stock Options

“Abusing” options is fairly simple. Just as an automobile insurance policy with no deductible gives its owner an incentive to file a claim for every little ding and scratch, an ITM option gives its owner an incentive to collect on every favorable move in the stock price. Many traders in the stock market, therefore, have found that they can just buy ITM Call options when they believe stock prices are poised to increase and ITM Put options when they think stock prices are headed down; then they simply collect on the insurance by cashing in the options if stock prices do indeed rise or fall, respectively. They may profit from rising or falling stock prices without ever owning a single share of stock; and since there is little or no deductible, the profit from the options may be nearly equal to profit that might have been earned on the stock.

The fact that options can be used in this manner – as surrogates for shares of stock – tends to alter their appearance to those looking at the options market from the outside. To an untrained observer, it can be difficult to discern those in the options market who are using options as surrogates for stock from those who are using options as insurance.

Thankfully, it is easy to separate those buying options as insurance from those buying options for other purposes:

• Out-of-the-money (OTM) strike prices tend to be used for speculation because they have very low premiums but very high deductibles
• At-the-money (ATM) strike prices tend to be used as insurance policies because they have moderate premiums and no deductibles
• In-the-money (ITM) strike prices tend to be used as stock surrogates because they have very high premiums but actually have negative deductibles (exercising the option provides a better price than trading the stock on the open market, in some cases the net premium or 'time premium' is nearly zero when considering the intrinsic value of the negative deductible) For example, if a stock is trading at $100 per share, a Call option with a strike price of $90 would have zero time premium if that Call option was trading at $10. Essentially the Call buyer is entitled to all the profits on the stock if it trades above $100 per share, plus $10 per share. The deductible in that case is actually negative: -$10, so the entire $10 premium would be recouped at stock prices above $100.

In general, the only options a trader will buy if those options are being used purely as insurance for stock positions, to protect gains for example, are those with strike prices very near the current stock price – ATM options. OTM and ITM options may be used for other purposes, but generally not for stock insurance because the deductible is far too high or far too low, respectively, for such options to be considered analogous to most other traditional insurance policies.

Traders may buy options at OTM strikes to limit risk on a stock or option position, and technically these options could be considered a form of insurance, but the fact that these options have a high deductible means the trader is accepting a good deal of risk. Essentially, any trader buying OTM options is speculating.

A trader who buys OTM options outright is speculating that the stock price will move significantly toward the strike price or beyond, while a trader who buys OTM options as a hedge against an existing stock or option is speculating that the stock price will not move significantly toward the strike price. For example, any trader who buys OTM Puts as protection for shares of stock that are owned is speculating that the stock price will move higher, since this trader would suffer significant losses (the deductible) before the stock reached the strike price.

A trader who buys an insurance policy with zero deductible (or a negative deductible) isn't truly buying insurance in the traditional sense either. Zero deductible policies are more analogous to a prepaid maintenance agreement than they are to traditional insurance. So too do ITM stock options more resemble prepaid stock positions than insurance policies. That's why ITM options lend themselves to being used (or abused) as stock surrogates.

Analyzing Options as Insurance

OTM options are used for speculation, ITM options are used as surrogates; only ATM options are used as insurance. Thus, it makes sense to analyze only ATM options when studying the options-trading environment from the perspective of it being a stock insurance industry.

When someone buys a house and insures it, they generally don’t expect to profit if the house burns down. They expect to be protected. When someone buys a car and insures it, they don’t expect to profit from running the car into a ditch. In either case, the insured will benefit from the insurance, but will still suffer some level of loss (the deductible).

If arsonists and bad drivers suddenly started profiting, it would be time to pay attention. In some ways, that is just what is happening right now for the S&P 500. Options that are normally used for insurance are returning profits for the option owners.

Options with at-the-money (ATM) strike prices are not just profitable for buyers these days, but uncommonly profitable. Buying options has suddenly become the profitable thing to do, not just for speculators and those using options as stock surrogates, but at strike prices that normally function only as insurance policies.

Obviously, no insurance industry is sustainable over the long term if those buying insurance are able to earn profits. That includes the options market. S&P 500 options used as insurance – ATM strike prices – cannot return profits for buyers indefinitely. The only reason profits are possible on any type of insurance is due to the fact that over the long term the seller of the insurance collects at least enough premiums to pay all the claims. Without sufficient premiums in the long term, the insurance industry collapses.

The options insurance industry is no different. It will not collapse in the long term because periods of profitability for buyers will always be offset by periods of profit for sellers. The current phase of profitability for buyers of ATM options on the S&P 500 is therefore an outlier – an anomaly.

Insurance-Buyer's Profit Indicates Irrational Market

While profits for buyers of ATM options on the S&P 500 are not uncommon, they don’t last forever, and generally disappear within a few weeks to a few months. It is therefore important for traders to know when these profits are occurring, and when they are not. Currently they are.

When insurance becomes profitable for policy owners it is time to pay attention. It represents a shift. For, if fire insurance became attractive to arsonists or car insurance became attractive to reckless divers, as a way to earn income, it would suggest that arsonists and reckless drivers were in control, at least temporarily.

So too are stock buyers and greed in control of an overbought stock market when stock insurance becomes attractive. It won’t last forever. It can’t. But an overbought stock can stay overbought for a long time, even if it is unsustainable in the long run. Who wouldn’t be tempted to join an unsustainable cause if it was profitable?

The fact that the current options market is unsustainable is what makes it so vitally important that folks pay attention to it. The fact that stock prices are still going up, even though ATM option buyers are profiting (when they normally do not profit) suggests the market has become irrational. It is pointless to argue with irrationality; much better to join in, knowing full well that it won’t last forever.

You are here – Bull Market Stage 1 – the “Lottery Fever” stage.

On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending December 6, 2014, this is how the trades performed on the S&P 500 index ($SPY or $SPX):

• Covered Call and Naked Put trading are each currently profitable (A+).
  This week’s profit was +2.9%.
• Long Call and Married Put trading are each currently profitable (B+).
  This week’s profit was +3.3%.
• Long Straddle and Strangle trading is currently profitable (C+).
  This week’s profit was +0.4%.

The combination A+ B+ C+ occurs whenever the stock market is at Bull Market Stage 1, the “Lottery Fever” stage, which gets its name from the irrational stock buying frenzy reminiscent of a lottery jackpot feeding upon the greed of ticket buyers hoping for a chance to win. The higher the jackpot the faster the ticket sales, and the faster the tickets are sold, the higher the jackpot.

The following weekly 10-minute 3-step process provides further analysis.

Weekly 3-Step Options Analysis: 

On the chart of “Stocks and Options at a Glance”, option strategies are broken down into 3 basic categories: A, B and C. Following is a detailed 3-step analysis of the performance of each of those categories.

STEP 1: Are the Bulls in Control of the Market?

The performance of Covered Calls and Naked Puts (Category A+ trades) 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, which balances sluggish responses of longer expirations with irrelevant noisy responses of shorter expirations.

Historically, any time Covered Call trading has become unprofitable, a full-fledged Bear market has ensued within a few weeks to, at most, a few months. That makes the recent October dip into unprofitability, the first such instance in 3 years for Covered Calls, a major signal for the potential of an upcoming Bear market. As bullish as the current market may appear, traders should be open to the possibility that a Bear market is certainly not impossible.

The unprofitability of Covered Call trading does not guarantee that a Bear market will occur soon, nor does it imply that stock prices cannot rally much higher in coming weeks. Rather, it indicates that similar conditions as currently exist have always resulted in Bear markets in the past. Traders should be prepared for the possibility that the current rally is a trap. Even if it turns out not to be a trap, it is better to be safe than sorry.

If the S&P falls below 1938 over the upcoming week, Covered Call trading (and Naked Put trading) will become unprofitable, indicating that the Bears retain control of the longer-term trend. Above S&P 1938 this week, Covered Calls and Naked Puts would be profitable, which is normally a sign that the Bulls are in control. However, such control is usually only temporary as long as the Bulls lack strength and confidence.

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.
• “If stock prices have been falling long enough to have caused extremely high implied volatility, as measured by indicators such as the VIX, and I can collect enough of a premium on a Covered Call or Naked Put to earn a profit even when stock prices fall drastically, the Bears have lost control.” It’s probably very near the end of a Bear market.

STEP 2: How Strong are the Bulls?

The performance of Long Calls and Married Puts (Category B+ trades) 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 which balances sluggish responses of longer expirations with irrelevant noisy responses of shorter expirations.

Profits from Long Call trading returned several weeks ago, a major signal of a return to bullish confidence and strength. Bear markets, even during the strongest bounces, have historically never been strong enough to cause Long Calls to profit. The current presence of Long Call profits therefore places serious doubt that a Bear market ever was ever underway, despite indications from Covered Call/Naked Put Index (#CCNPI) to the contrary. The contradiction is the first of its kind in at least 10 years, so in some ways the S&P is in uncharted territory now.

As long as the S&P closes the upcoming week above 2039, Long Calls (and Married Puts) will remain profitable, suggesting the Bulls have regained confidence and strength. Levels above 2039 would suggest a significant shift in sentiment, notably a huge return of confidence by the Bulls.

Confidence and strength show up as a “buy the dip” mentality, while a lack of confidence and strength produces a “sell the rip” sentiment that tends to create brick-wall resistance, since each high is perceived as a rip to be sold. In a true Bear market, the Bulls will never be confident and strong; thus, Long Calls and Married Puts will never profit during a Bear market. Profits are therefore compelling evidence that the Bulls are firmly in control.

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, they are also 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 or Bears Overstepped their Authority?

The performance of Long Straddles and Strangles (Category C+ trades) 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, which balances sluggish responses of longer expirations with irrelevant noisy responses of shorter expirations.

The LSSI currently stands at +0.4%, which is high but normal, and indicative of a market that is overbought but sustainably so, and not in imminent need of a major correction from. It does not mean a correction will not occur for other reasons, for example poor economic news, just that a correction is not yet likely due to overbought stock prices. Positive values for the LSSI represent profits for Long Straddle option trades. Small profits are quite common when a Bull market has become irrationally exuberant – sustainably overbought. Large profits only occur when stock prices have become unsustainably overbought.

The 3 unusual conditions for a Long Straddle or Long Strangle trade are:

• Any profit
• Excessive profit (>4% per 4 months)
• Excessive loss (>6% per 4 months)

Long Straddle trading (and Long Strangle trading) will remain profitable during the upcoming week as long as the S&P closes above 2089. Values above S&P 2089 could only occur during an irrationally exuberant Bull market. Values above 2089 would therefore suggest the presence of an overbought market, but sustainably overbought.

Excessive Long Straddle trading profits (more than 4%) will not occur unless the S&P either exceeds 2168 this week. Values above 2168 can only occur in a roaring Bull market, but would suggest that stock prices have risen too far too fast for the rate to be sustainable, thus needing to correct lower, at least temporarily, in order to return to sustainability for the uptrend.

Excessive Long Straddle losses (more than 6%) will not occur unless the S&P moves to very near 1969 this week. Since excessive losses tend to coincide with a desire for traders to make stock prices break out, either higher or lower than the boundaries of their recent range, a level of the S&P near 1969 would likely bring a violent snap-back rally or else a violent resumption of the most recent downtrend.

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 just been moving quickly, but at a rate that is surprisingly fast.” Profits warrant concern that a Bull market may be becoming over-bought or a Bear market may be becoming over-sold, 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 trend has been ridiculous and unsustainable.” No matter how much strength the Bulls or Bears have, they have pushed the market too far, too fast, and it needs to correct, at least temporarily.
• “If I pay both premiums and suffer a loss of more than 6%, then the market has become remarkably trendless and range bound.” The stalemate between the Bulls and Bears has gone on far too long, and the market needs to break out of its current price range, either to a higher range or a lower one.

*Option position returns are extrapolated from historical data deemed reliable, but which cannot be guaranteed accurate. Not all strike prices and expiration dates may be available for trading, so actual returns may differ slightly from those calculated 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