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This Week’s Worst Option Strategies | zentrader.ca

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By Chris Ebert

No matter how the stock market is behaving there are almost always ways to profit using options. The trick is to know which option strategy is most likely to return the highest risk/reward profile in the current market. Not every strategy works in every market, and the following charts of this week’s option indices make that perfectly clear.

Covered calls and naked puts opened at-the-money using broad market ETFs performed almost flawlessly beginning last December and continued to do so through early May. Whether they were opened using weekly options, monthly or 4-months out, they almost always returned a significant profit.

The Covered Call/Naked Put Index (CCNPI) tracks the performance of these trades. Because such strategies only result in losses in a bear market, the CCNPI is an indicator of bearish or bullish market sentiment. In addition to showing changes in sentiment, the CCNPI also depicts trends in each strategy that can help an option trader decide when the time is right to open an at-the-money covered call or naked put. Given the current trend, now is not the time.

Covered Call/Naked Put Index

The Long Call/Married Put Index (LCMPI) also tracks performance using weekly, monthly and 4-month-out at-the-money options. There was a time earlier this year when the market was conducive to these trades. The LCMPI is an indicator of bullish strength, and currently it is not showing any. Because at-the-money long calls and married puts only perform well in a strong bull market, the trend indicates that now is not the time for these trades either.

Long Call/Married Put Index

The Long Straddle/Strangle Index (LSSI) is negative again this week, as it has been for most of 2012. The LSSI measures the justification of fear in the market. Long straddles are only profitable when traditional fear indicators such as the VIX are doing a poor job at predicting the magnitude of upcoming trends. For most of 2012, trader’s fears have been justified and therefore the LSSI has been within normal limits, and this week is no different. Because the market is behaving normally, the trend indicates that now is not the time for long straddles or strangles.

Long Straddle/Strangle Index

This week’s featured option trade

Market conditions have not been favorable recently for many of the common option strategies that comprise the option indices. Fortunately, it is almost always possible to structure an option trade, no matter what the market is doing. This week’s focus will again be on safety, due to the combination of bearish sentiment and the choppiness of the market.

This trade takes several factors into account:

The S&P has recently encountered resistance around 1360 Recent events in Europe are weighing down markets US manufacturing and employment numbers continue to be disappointing The Fed seems unlikely to announce any new policies in the next few weeks

Last week’s featured trade

Last week’s 1:2 ratio bull call spread moved into profitable territory early this week. While the trade now appears unlikely to generate a profit if held through this week’s expiration, a profit of several hundred dollars was easily obtainable. A stop loss or trailing stop works as well on an option trade as it does on a stock trade. In this case a stop would have prevented a win from becoming a loss.

Questions about these or any other option trades are encouraged. Please enter them in the comment section below, or email them to optionscientist@zentrader.ca.

All Index values are calculated relative to the S&P 500 using volatility data to extrapolate the theoretical performance over the given time periods. It is not possible to match the exact performances shown because the strike prices and expiration dates available in actual trading will always differ from those used in the calculations.

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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