By Chris Ebert

Stocks and Options at a Glance

Another week of Lottery Fever is behind us. The thing about Lottery Fever is that it sets the bar quite high. Stock prices have been going up, week after week, month after month, with nothing more than a minor pullback to briefly pause the uptrend. That’s fine… as long as it lasts. But what happens when prices stop rising so quickly (we all know the current pace won’t last forever)?

The Options Market Stages were designed to provide insight into future conditions of the stock market as well as the current condition. The intent here is not so much to predict what the market will do tomorrow, because nobody really knows for sure, but rather to prepare traders for a series of “What ifs”.

  • What if the S&P goes to 1740 this week?
  • What if there is a 2% sell-off?
  • What if the market gets stuck here until September?

Below is the weekly chart showing where the market stands today. What follows is an analysis of  future market conditions that attempts to answer all of those “What ifs”.

Click on chart to enlarge

Click on chart to enlarge

*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)

You Are Here – Bull Market Stage 1

The profitability of Long Straddle trading defines Bull Market Stage 1. For the upcoming week (ending August 3) Long Straddle trading will remain profitable as long as the S&P remains above 1673. That is an indication that “lottery fever” will continue if the S&P does not fall below 1673 this week.

The profitability of Long Straddle trading occasionally reaches ridiculous and absurd levels. Often a profit of more than 4% signals an upcoming correction on the order of 10% off recent highs in the S&P. If the S&P was to reach 1736 this week, Long Straddle profits would reach that 4% threshold and would thus signal the possibility of an upcoming correction. Corrections do not always occur immediately after Straddles return 4% profits, but there has been a strong correlation between such profits and subsequent corrections over the past 10 years.

Where Do We Go From Here?

Because the Options Market Stages are dependent upon the performance of actual, tangible, real-life option trades, the level of the S&P which would trigger each of those stages varies from one week to the next. This is a sharp contrast to static levels of support or resistance, where the level remains constant over a period of time.

On the following chart it can be seen that if the S&P was to exceed 1740 during the first week of August, it would push Lottery Fever to its limit. However, if the S&P slowly melts its way up to 1800 by mid-September, that would not push Lottery Fever beyond its upper limit. It is an important distinction, since exceedance of the limit has historically been associated with market corrections.

CLICK HERE for a complete chart of all Option Market Stages

Options Stages Projection 07-27-13

Another way to look at the chart is to see how far the market can sell off before it enters a new stage, thus taking on the character associated with the new stage. For example, a 2% decline between now and mid-August would likely not result in any major behavioral changes in the stock market, as Lottery Fever would continue.

Perhaps one of the more striking implications of the chart is that a Bear Market is currently far, far away – at least in terms of price. The S&P could conceivably fall into the low 1500s this August, and as long as it found support at that level the argument could be made that the sell-off was nothing more than a healthy Bull market correction. However, going out to November, we could conceivably find ourselves in a Bear market, even with the S&P not too far off its current level in the upper 1600s.

That may seem inconceivable – that we could potentially be in a Bear market if the S&P was at, say, 1640 in November. That’s how Lottery Fever works though – it gets traders so accustomed to ever-increasing stock prices that a few months of sideways prices combined with the slightest pullback can potentially turn into a Bear market.

Again, it is worth repeating that the Option Market Stages are not intended to predict a Bull or a Bear market. For example, they are not predicting that the S&P will be at 1640 in November. They are indicating that should  1640 occur in November would likely be accompanied by a very Bearish environment. That’s not because 1640 is a major support level or because it represents a major Fibonacci retracement level, etc.; it merely represents a market in which Covered Call trading is no longer profitable, and generally Covered Call trading is only unprofitable in a Bear market.

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.

 Covered Call Trading

This week, Covered Call trading and Naked Put trading were both profitable, as they have been for an extended period. In fact, Covered Call trading became profitable in late 2011 and has remained profitable every week since then except for two very minor losses. That means the Bulls have been in control since late 2011 and remain in control today. As long as the S&P remains above 1547 over the upcoming week, the Bulls will retain control of the longer-term trend. 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.

 Long Call Trading

This week, Long Call trading and Married Put trading were both profitable, as they have been since February 1, 2013. That is a historically long streak of profitability, and an indication that the Bulls are stronger and more confident now than they have been at any time in the past 10 years. It will take something really big to upset their apple cart now. As long as the S&P closes the upcoming week above 1631, the Bulls will retain confidence and strength. 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

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 few weeks ago, on June 22.

Long Straddle trading returned to profitability on July 19, 2013; a relatively rare event given that either a correction on the order of 10% or so, or several months of sideways digestion often occurs between streaks of profitability for Long Straddles, neither of which was present this time. Although the data is scarce, such reversions have been associated with double tops in the past, and these short-lived rallies tended to end with a significant correction.

While the June pullback in stock prices does not meet the criteria of a typical Bull market correction, it is quite possible that a true 10% correction may still occur. A level of the S&P above 1736 this coming week would push the LSSI over 4% signaling that the market was “Due for a Correction”. 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:

2013: What A Year For Option Straddle Trading

Options Warn Of Danger Above S&P 1720

Rare Reversion To Stage 1 May Signal Double Top

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