By Chris Ebert
An analysis of stock options reveals that traders of Cooper Tire (CTB) are likely to feel strongly bullish, and the recent pullback from the $23 level appears to be nothing more than a much needed correction. Further analysis indicates the current trading range of $20-$21 may not represent enough of a correction. This suggests that it may take some additional selling, perhaps to as low as the $18 range in order to propel the stock back over its recent $23 highs. Otherwise, the current level will tend to act as resistance, and the stock may meander around $20 for the next month or so before buyers start feeling impatient again. While there is currently no reason to suspect a more drastic selloff is imminent, a correction to $16 would require a serious re-evaluation of Cooper.
Because option premiums are based on emotions, the profitability of these trades is highly dependent on emotions as well. The profit or loss of option trades can therefore reveal the emotions of traders. If the emotions are known, the decision of when to buy or sell a stock can be made with more confidence. A study of stock options can therefore be helpful, even for traders who do not trade options or understand how they function.
- Covered call performance reveals whether traders feel bullish or bearish
- Long call performance reveals whether traders feel a stock is strong or weak
- Long straddle performance reveals whether traders feel surprised
Covered call options are best known as income-producing trades. Since they generate income, they only result in losses when traders of a stock are bearish – when the income is insufficient to offset the decline in the underlying share price. Covered calls opened 112 days before expiration react quickly to changes in a trend while smoothing out weekly swings that have little effect on the overall trend. At-the-money covered calls on CTB are currently profitable, when opened 112 days before expiration; therefore traders are likely to feel bullish. Covered calls will remain profitable, and therefore traders are likely to remain bullish, so long as CTB shares remain above $16 over the next few weeks. Prices below $16 would be a definite bearish signal.
The strength of bullish emotions can be determined by a different type of option trade, the long call. When an underlying stock price rises fast enough to overcome the premium required to purchase an at-the-money call option, 112 days before its expiration, traders are likely to feel confident in the strength of the stock. Long call options on CTB are currently profitable; therefore traders are likely to feel confident in the strength of the stock. Long calls will remain profitable, and therefore traders are likely to remain strongly bullish, so long as CTB shares remain above $18 over the next few weeks. Prices below $18 would be an indication of weakness and a warning to prepare for the possibility of $16 and subsequent bearishness.
Regardless of covered call performance currently indicating bullishness, and long call performance indicating strength, it is possible for trader’s emotions to be unjustified. Traders sometimes remain bullish when a stock may actually be headed for a correction or worse, a breakout to a lower trading range. This condition can be measured by another type of option trade, the long straddle.
A long straddle is an expensive trade to open, since it requires the purchase of both an at-the-money call and put option. The high expense tends to greatly reduce any profits. Straddles on a diversified fund such as one tracking the Dow, S&P or NASDAQ rarely return a profit greater than 4%, while straddles on individual stocks rarely return a profit of more than 8%. When such a trade, opened 112 days before expiration, results in a profit of more than 8% it is an indication that traders were taken by surprise – the stock price moved more than most of them expected. This can be a dangerous condition because the stock price has come too far, too fast, to make traders comfortable, and often results in a correction.
When a long straddle results in a loss of more than 6% on a diversified fund, or 12% on an individual stock, it is also an indication that traders were taken by surprise – most expected the stock to move and it didn’t. This also represents a dangerous condition because traders are then likely to drive the stock to make a big move, but the direction of the move is often not easily predictable. A 112-day Long Straddle loss exceeding 12% often precedes a breakout below support that either confirms trader’s prior fears or a breakout above resistance that completely puts those fears to rest.
Long straddles on CTB have been producing profits well in excess of 8% in recent weeks. The recent pullback off of the $23 highs back to the $20 level has reduced the profits on straddles, but not to a level that may be considered normal. For now it would appear that the recent selling was part of a correction that has relieved much of the previous over-bought condition. But the performance of straddles indicates that many traders may still feel that it is over-bought. This condition is usually resolved in one of two ways:
- The stock price quickly corrects more, down to the $18 range, making it “due for a breakout” followed by a breakout above the recent $23 highs or below $14.50 support.
- The stock price consolidates around $20 for a month or two, again making it “due for a breakout” above $23 or below $14.50.
Option position returns are extrapolated from historical data that, while reliable, cannot be guaranteed accurate. It is not possible to match the exact performances shown, because the strike prices and expiration dates used in the calculations will not always be available in actual trading.
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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