By Chris Ebert
Ever notice how the stock market seems to have a mind of its own, as if it is determined to separate you from your stock positions? If so, you are not imagining things. The stock market is indeed hunting you down; but don’t take it personally. It is simply the nature of the stock market to break the bonds between stocks and stockholders; and it’s called entropy.
Entropy is, quite simply, a tendency toward disorder. It isn’t confined to the stock market. Entropy favors an organized, predictable stock market as much as it favors a sand castle on the beach or a hot cup of coffee. Without outside influence, in time, each of these will return to their natural, disorganized state – the coffee’s organized collection of heat scattered haphazardly throughout the air just like the castle’s organized grains of sand on the beach or stock prices from any level that conveys certainty or order.
Some stock price levels convey more certainty for traders than others. Since the natural tendency is always towards a level of increased uncertainty and increased disorder, knowing which levels are likely orderly and which are prone to be disorderly man help a trader prepare for the next move.
Predicting order is nothing new. In fact, it is the basis for many common trading methods. From candlestick analysis to Darvas boxes, trend lines to Fibonacci retracements, the goal is the same – to search the market for fleeting moments of certainty and order, and pounce on them before entropy runs its course.
There are numerous ways a trader can analyze potential levels of order and disorder, the performance of some simple stock options being one of the simpler methods. An analysis of S&P 500 options may provide some clues as to when broad-based uncertainty and disorder is likely in the stock market as a whole, and when it is not. It begins with determining which types of common option trades on the S&P 500 are currently profitable.
* All profits are calculated at expiration, as a percentage of the underlying SPY share price. SPY is an ETF that closely tracks the performance of the S&P 500, specifically the SPDR S&P 500 ETF Trust (NYSEARCA:SPY). All options are ATM-when-opened 4 months (112 days) to expiration. (e.g. Profit of $6 per share on a Long Call would represent a 3% profit if $SPY was trading at $200, even if the call premium itself actually increased 50%, 100% or more)
You are here – Bull Market Stage 2 – the “digesting gains” Stage.
On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending August 16, 2014, this is how the trades performed:
- Covered Call and Naked Put trading are each currently profitable (A+).
This week’s profit was +3.1%.
- Long Call and Married Put trading are each currently profitable (B+).
This week’s profit was +1.7%.
- Long Straddle and Strangle trading is currently not profitable (C-).
This week’s loss was -1.4%.
Using the chart above, it can be seen that the combination, A+ B+ C-, occurs whenever the stock market environment is (more…)