By Chris Ebert
Stocks and Options at a Glance
As far as stock market rallies go, it really can’t get much better than this. The market has a speed limit; and major stock indices such as the Dow and the S&P 500 are limited as to the rate that they can rise. The S&P is currently traveling very near – but just under – the speed limit, so this truly is as good as it gets.
Sure, the S&P can rise faster than its current rate; the market does what it wants. But there are consequences when stock prices rise too fast. At some point, when the market exceeds the speed limit, there will come a time when there are more stock owners willing to sell their shares at a hefty profit than there are buyers willing to buy those shares at such an inflated price. The result is that sellers have to lower their asking price to attract buyers, so prices fall, which further inhibits buyers, causing sellers to lower their asking price even further – a.k.a. a market correction.
So, exactly how does one determine the speed limit for the S&P? One very effective method is to use the performance of a simple option strategy as a gauge. The S&P can only rise at a rate that allows Long Straddle trading* to achieve a profit of 4% or less, in 4 months. Anything over 4% indicates that the S&P is exceeding its speed limit. The 4% limit is based upon an analysis of historical performance over the past ten years.
Long Straddle profits are a hallmark of Bull Market Stage 1 – the “lottery fever” stage, as shown below. If one were to choose the best possible stock market environment, it would likely be the lottery fever stage. Lottery fever allows buyers of stocks to earn profits quickly with minimal chances of being scared away or stopped out. However, this is only true if lottery fever does not get out of hand and does not push Long Straddle trading profits above 4%. Currently, those profits are under 4%, hence the conclusion that the current stock market is as good as it gets. A detailed analysis follows below.
*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
Lottery fever began infecting the stock market on March 1, 2013 when Long Straddle trading became profitable, and this marked the beginning of Bull Market Stage 1. It has continued ever since, except for a brief movement to Stage 2 during the pullback in stock prices this past June.
Because stock prices have been rising so fast, for so long, traders are quick to dismiss any negative economic news. In fact, any negative news that results in falling stock prices tends to be perceived as a buying opportunity that sends stocks to even higher levels. Several major catalysts have had an impact on the market in recent months, each with potential negative consequences, yet each has eventually resulted in higher stock prices. Some examples are the Fiscal Cliff, the Debt Ceiling, the Sequester, and most recently, the Taper.
Where Do We Go from Here?
Nobody knows for sure where this market is headed; nobody! But, based on the speed limit, and the market’s historical adherence to that limit, it is not out of the question that the S&P could hit 1825 in September and 1900 by the end of the year. But, that is only if the market continues at its current pace. Any number of catalysts could act upon the market between now and then which could send stock prices tumbling. Still, those levels are worthwhile to note, because they themselves could be a catalyst for a correction, even in the absence of troubling economic developments, should those levels be exceeded. Lottery fever sometimes runs its course without any outside interference.
It is never healthy for Long Straddle trading to return profits in excess of 4% in 4 months. If the S&P was to exceed 1825 in September or 1900 by the end of 2013, such profits would indeed be greater than 4%. Of course, if something else spooks the market before then, we may never get to those levels, and lottery fever may end as a result of as-of-yet unknown outside forces.
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. 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 1535 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.
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 1630, 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.
The LSSI currently stands at 2.2%, which is high but not abnormally so. It does indicate that the Bulls have overstepped their authority a bit, but that is to be expected occasionally when the market is rallying. Sometimes traders start taking their profits off the table when the LSSI gets above zero in a Bull market, and the result can be a temporary pullback or correction. Other times stock prices continue higher and this pushes the LSSI above 4.0%, which makes a correction even more likely, as even more traders are likely to walk away with their profits.
A level of the S&P above 1740 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 the next occurrence 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.
Updates to the above analysis may be found at @optionscientist
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!”
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