By Chris Ebert
The S&P 500 has hovered around the 2100 level quite a bit recently. That didn’t happen by chance; there’s a very good reason that level is so important right now. It represents a battle zone; and perhaps there is no better way to view that battle zone than by looking at some simple stock options.
Covered Call options generally only return losses in a Bear market. Of course, there are always exceptions to any rule. But, for the most part, a Covered Call* (*see specific description below) will always return a profit during a Bull market, and only return a loss during a Bear market.
S&P Can’t Loiter on Bull-Bear Border
The reason the S&P 500 cannot straddle the dividing line between a Bull and Bear market is that the moment stock prices would move in one way or the other, one side or the other would declare victory and the battle would be over. If stock prices rose, even slightly, the Bulls would declare victory and the victory party would send stock prices even higher, reinforcing that victory.
On the other hand, when the S&P 500 is straddling the line, the slightest dip in stock prices will be a victory for the Bears, and not only will the Bears send prices lower, the fear generated in the minds of the Bulls by such a victory will push many of them to sell their stock positions, in turn adding fuel to the sell-off.
Since the S&P 500 cannot straddle the Bull/Bear dividing line for any extended period of time, and since Covered Call profitability is one way of easily identifying the dividing line, then it stands to reason that the point of Covered Call profitability is a point that is unsustainable for the S&P 500.
Covered Calls are either profitable (and it is a Bull market) or they are not (and it is a Bear market). The S&P 500 rarely sticks around very long at the dividing line between Covered Call profit and loss. Thus, the S&P 500 (the white line in the chart) will rarely hug the red line on the chart. Generally, the S&P either bounces off the red line, or else it passes right thorough without stopping. But it almost never sticks around for a hug.
The dividing line between a Bull market and Bear market is usually not a place of protracted battles. Rather, long drawn out battles tend to take place inside one’s own territory. That’s the case at the moment, as the Bulls are engaged in a battle near the 2100 level for the S&P, well inside Bull-market territory.
Nobody Likes a “Correction”
Next, consider that for any Bear market, there is a zone just above it that is not quite bearish, but considered more of a correction. If Covered Calls are used to define a Bull and Bear market, then Covered Calls (which only return losses in a Bear market) must always be profitable in a Bull-market correction, by definition. Only when the correction becomes so severe that it morphs into a Bear market do Covered Calls suffer losses.
While Covered Calls do return profits during a correction, it turns out that (more…)