By Chris Ebert
Stocks and Options at a Glance
A week ago, we entered Bull Market Stage 2 – the “digesting gains” stage after having endured several months at Stage 1 – the “lottery fever” stage. That was an important change because it marked the end of an era, at least temporarily, in which stock prices seemed to have nowhere to go but up.
The change from Stage 1 to Stage 2 can be identified by the change of Long Straddle option trading from profitable to unprofitable. In a Bull market, Long Straddle trading is only profitable when the uptrend is surprisingly strong, so much so that the rate of increase is ridiculous and unsustainable. Stage 2 represents a much more sustainable uptrend, but the change of pace often spooks traders and results in a progression to Stage 3.
We are now within sight of Stage 3 – the “resistance stage”. The change to Stage 3 can be identified by a change in Long Call trading from profitable to unprofitable. Long Call trading is only profitable when a Bull market is strong enough that stock prices often rise, seldom move sideways, and if there is a minor pullback it is short-lived and does not significantly affect the general upward trend. When Long Call trading becomes unprofitable, the general uptrend becomes questionable, at least in the near term.
*All strategies involve at-the-money options opened 4 months (112 days) prior to this 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)
Long Call trading would have become unprofitable this past week (ending June 29) if the S&P 500 had remained below 1594. For the upcoming week (ending July 6), the change to unprofitability would occur if the S&P was to remain below 1601. The option trades are not predicting that the S&P will fall below 1601, but simply indicating that the stock market would experience a change in attitude if next Friday’s close was below 1601. That change in attitude would coincide with the progression to Stage 3. At Stage 3 the only remaining profitable bullish strategies are Covered Call trading and Naked Put trading.
You Are Here – Bull Market Stage 2
At Stage 2 there is still some hope of returning to recent market highs in the very near future, and perhaps exceeding them. Even though it would seem unlikely for the S&P to return to record highs in the upcoming days, it cannot be entirely ruled out. That’s what makes Stage 2 a difficult market to trade.
Even though there appear to be widespread arguments that there is more room for a deeper correction in the uptrend of recent months, the memory of those record highs of late May makes this a difficult market to short. It’s also difficult to go long when violent selloffs have become a common occurrence.
Stage 3 is often a less risky market to short, because the recent highs tend to become distant memories. A return to those past levels would likely be met with very strong resistance. That level of resistance tends to become a brick wall once the market reaches Stage 3, in effect giving short sellers a better defined risk of loss.
The lowered perceived risk of shorting can sometimes add to selling pressure, exacerbating the market’s tendency to play out a full-fledged correction. In other words, Stage 3’s definition of “resistance” can sometimes quickly pave the way to Stage 4 – the “correction” stage.
What Happens Next?
- Stage 1 gave way to Stage 2 on June 22 when Long Straddle trading became unprofitable.
- Stage 2 will continue as long as the S&P remains between 1601 and 1642 at the close on Friday, July 5.
- Although not historically probable, a level above 1642 would represent a reversion to Stage 1.
- Stage 2 will give way to Stage 3 if Long Call trading becomes unprofitable, which would occur if the S&P was to remain below 1601 through Friday July 5.
- Stage 3 will give way to Stage 4 if Covered Call trading becomes unprofitable, which would occur is the S&P was to remain below 1520 through Friday.
- If after reaching 1520 this week, a bounce caused Covered Call trading to become profitable again, the market would progress to Bull Market Stage 5, most likely representing the end of the correction and a resumption of the Bull market.
- If after reaching 1520 this week, the downward spiral continued and Long Straddle trading became profitable again, the market would progress to Bear Market Stage 5, indicating that subsequent bounces would likely be temporary pauses in a longer downturn.
Weekly 3-Step Options Analysis:
On the chart of “Stocks and Options at a Glance”, option strategies are broken down into 3 basic categories: A, B and C. Following is a detailed 3-step analysis of the performance of each of those categories.
STEP 1: Are the Bulls in control of the market?
The performance of Covered Calls and Naked Puts (Category A+ trades) reveals whether the Bulls are in control. The Covered Call/Naked Put Index (CCNPI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames. Most important is the profitability of these trades opened 112 days prior to expiration.
This week, Covered Call trading and Naked Put trading were both profitable, as they have been for an extended period. That means the Bulls remain in control. The reasoning goes as follows:
• “If I can sell an at-the-money Covered Call or a Naked Put and make a profit, then prices have either been going up, or have not fallen significantly.” Either way, it’s a Bull market.
• “If I can’t collect enough of a premium on a Covered Call or Naked Put to earn a profit, it means prices are falling too fast. If implied volatility increases, as measured by indicators such as the VIX, the premiums I collect will increase as well. If the higher premiums are insufficient to offset my losses, the Bulls have lost control.” It’s a Bear market.
• “If stock prices have been falling long enough to have caused extremely high implied volatility, as measured by indicators such as the VIX, and I can collect enough of a premium on a Covered Call or Naked Put to earn a profit even when stock prices fall drastically, the Bears have lost control.” It’s probably very near the end of a Bear market.
STEP 2: How strong are the Bulls?
The performance of Long Calls and Married Puts (Category B+ trades) reveals whether bullish traders’ confidence is strong or weak. The Long Call/Married Put Index (LCMPI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames. Most important is the profitability of these trades opened 112 days prior to expiration.
This week, Long Call trading and Married Put trading were both profitable, but not nearly as profitable as in recent weeks and months. Both forms of trading became profitable in late January, indicating that the Bulls were not only in control, but also confident and strong.
The recent sell-off has decreased the confidence of the Bulls, so much so that if the S&P remains below 1601 through the upcoming week (ending July 6), any remaining confidence will disappear. Below S&P 1601, previously profitable Long Call trading will become unprofitable and the Bulls will become weak. The reasoning goes as follows:
• “If I can pay the premium on an at-the-money Long Call or a Married Put and still manage to earn a profit, then prices have been going up – and going up quickly.” The Bulls are not just in control, they are also showing their strength.
• “If I pay the premium on a Long Call or a Married Put and fail to earn a profit, then prices have either gone down, or have not risen significantly.” Either way, if the Bulls are in control they are not showing their strength.
STEP 3: Have the Bulls or Bears overstepped their authority?
The performance of Long Straddles and Strangles (Category C+ trades) reveals whether traders feel the market is normal, has come too far and needs to correct, or has not moved far enough and needs to break out of its current range. The Long Straddle/Strangle Index (LSSI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames. Most important is the profitability of these trades opened 112 days prior to expiration.
Long Straddle trading and Long Strangle trading became profitable on March 1, 2013. That marked the beginning of a surprising uptrend in stock prices. The profits continued uninterrupted for 16 weeks, the second longest winning streak in the past 10 years before finally returning to losses a week ago, on June 22.
While the recent pullback in stock prices does not yet meet the criteria of a typical Bull market correction, it is quite possible that a correction may still occur. An elevated LSSI has always led to a correction in the past, and there’s no reason to suspect this time will be an exception. It’s just a matter of how long until it occurs. The reasoning goes as follows:
• “If I can pay the premium, not just on an at-the-money Call, but also on an at-the-money Put and still manage to earn a profit, then prices have not just been moving quickly, but at a rate that is surprisingly fast.” Profits warrant concern that a Bull market may be becoming over-bought or a Bear market may be becoming over-sold, but generally profits of less than 4% do not indicate an immediate threat of a correction.
• “If I can pay both premiums and earn a profit of more than 4%, then the pace of the trend has been ridiculous and unsustainable.” No matter how much strength the Bulls or Bears have, they have pushed the market too far, too fast, and it needs to correct, at least temporarily.
• “If I pay both premiums and suffer a loss of more than 6%, then the market has become remarkably trendless and range bound.” The stalemate between the Bulls and Bears has gone on far too long, and the market needs to break out of its current price range, either to a higher range or a lower one.
*Option position returns are extrapolated from historical data deemed reliable, but which cannot be guaranteed accurate. Not all strike prices and expiration dates may be available for trading, so actual returns may differ slightly from those calculated above.
Questions, comments and constructive criticism are always welcome. Enter them in the comment box below, or send them to OptionScientist@zentrader.ca.
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!”
Related Options Posts: