By Chris Ebert

altimiterFor those who trade by the chart, known as technical analysts, it is never a good idea to ignore the chart, even when the chart appears to be giving mixed signals. To ignore the chart is like ignoring an airplane’s altimeter.

There is an old saying in aviation: “Always trust your gauges!” and it holds true for traders who use technical tools as gauges of stock market behavior. Nevertheless, it doesn’t hurt to tap on the gauge a few times to make sure it is working properly. That’s the situation this Memorial Day holiday in the U.S. – the gauges appear to be malfunctioning yet it is important to always trust the gauges.

The gauge in question is the Options Market Stages, which measures option performance on the S&P 500 index. This past week, Long Call option trades began profiting for the first time in three months. Specifically, $SPY or $SPX Long Calls opened at-the-money 4-months ago returned a profit when they expired this past week. Normally Long Call profits are a sign of bullish strength.

OMS 05-21-15a

All strategies involve options opened at-the-money 4-months (112 days) prior to this past week’s expiration using an ETF that closely tracks the performance of the S&P 500, such as the SPDR S&P 500 ETF Trust (NYSEARCA:SPY)

The problem, as can be seen on the chart above, is that the only reason Long Calls turned a profit is because of a temporary dip in the threshold. Last week, for one week only, Long Calls would have profited at a much lower level of the S&P 500 than the week prior or the week after.

Long Call Options Explained

A Long Call is a type of option that allows a trader to buy stock at a preset price. When someone buys a Long Call, they are buying the right to buy the stock, but they are not obligated to buy the stock. That set-up –  the right to buy but not the obligation to buy – can come in very handy. For example, a trader might buy the right to buy a stock at $100 per share (known simply as a $100 Long Call option). If the stock price soars to $120 a share, the right to buy the stock at $100 suddenly becomes very attractive and the trader will almost certainly exercise his right to buy. On the other hand, if the stock price falls to $80 the right to buy the stock at $100 would be worthless, and since the trader has no obligation to exercise his right to buy at $100 per share, he almost certainly will not.

Long Calls are similar to stock ownership in that they provide profits when stock prices rise. But they protect a trader from losses when stock prices fall, since the trader is never obligated to buy the stock. Perhaps obviously, the protection from losses when stock prices fall is a valuable tool in the stock market. That makes Long Calls desirable among stock traders. As such, Long Calls are sold at a premium – a price higher than what they are intrinsically worth. The premium is similar to the premium that might be found on an insurance policy. A trader who buys a Long Call pays a premium and gets insurance against excessive losses in the stock market.

Because there is a premium on Long Call options, stock prices must rise quite a bit just to overcome the cost of the premium. If stock prices remain steady or rise only slightly the trader who buys a Long Call option often will suffer a loss because the gains on the stock won’t be enough to offset the premium that was paid for the option. Because of this relationship between Long Call premiums and stock market profits, Long Calls make a good gauge of bullish strength in the stock market. When stock prices are rising fast enough so that Long Call traders make a profit, over and above the cost of the Long Call premium, its a good bet that the stock market is under the influence of bullish strength.

When broad baskets of stocks are measured in this manner, by looking at Long Call performance, the overall bullish strength of the stock market as a whole can be gauged. One particularly accurate gauge is the performance of Long Calls opened at-the-money 4-months to expiration using $SPY or $SPX options. When these specific Long Calls are profitable at expiration, the stock market is strong and healthy (that’s what happened this past week). When these Long Calls are not profitable at expiration, the stock market is weak; and trader’s confidence tends to become weak as well.

Outlook for Long Call Options

Next week the threshold for Long Call profitability rises to near the 2180 level for the S&P. So, if the gauges are to be trusted implicitly, it would appear that the S&P is in a position in which an explosive rally is possible – a rally of 50 points or more in a single week. On the other hand, rallies of that magnitude are rare, particularly in mature Bull markets such as the current one.

Given the rarity of one-week 50-point rallies in the S&P, it is quite likely that last week’s venture into Options Market Stage 2 was just an anomaly. This coming week, the market will tap on the gauge to see if it’s working properly. If it is, the Bulls are in for a wild ride higher for stock prices. If it’s not working correctly, the S&P will sink back into Stage 3 this week.

Stage 3 has been the status quo in 2015. It is known as the resistance stage because it tends to result in the S&P 500 hitting a brick wall of resistance when it reaches up to the level of recent highs. In this case, those recent highs are all-time record highs. So, a brick wall of resistance would be evident if the S&P tested the all-time high and either failed to top it, or else set a new record a few points higher – but not 50 points higher.

If a new record occurs this week, well above the current one, say, in the 2160s or 2170s or higher, then the gauge was working properly all along. That’s the number one concern for the stock market this Memorial Day: whether the S&P has suddenly shown a spurt of bullish strength or whether it was a one-week anomaly that will be followed by continued stagnation similar to what the past several months have produced.

The preceding is a post by Christopher Ebert, Chief Options Strategist at Astrology Traders (which offers subscribers unique stock-trading perspectives and options education) and co-author of the popular option trading book “Show Me Your Options!” Chris 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

Related Options Posts:

Thursday Evening Options Brief 2015-05-21

Surviving Stock Market Purgatory

Options Suggest S&P Primed for Catalyst

 

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