By Chris Ebert

Stocks and Options at a Glance

Each week, an analysis of stock options is published here, not only to allow option traders to see which option strategies are currently profitable and which are not, but to allow stock traders to gain insight into the future condition of the stock market.

The analysis presented here is not intended to predict what might happen next – although options do provide some predictive properties – but to allow traders to prepare for what will happen next; it is sort of like a road map for traders, with landmarks that serve as confirmation that the market has entered a new environment.

The market did indeed enter a new environment last week, one in which Long Straddle option trading became unprofitable. Since Long Straddle profits are a hallmark of Bull Market Stage 1 – the “lottery fever” stage, the change to unprofitability is an important landmark; it indicates that lottery fever has come to an end, at least temporarily.

The lottery fever stage of the stack market is an environment in which stock prices seem to have nowhere to go but up, attracting buyers in a similar fashion to the way a large jackpot attracts buyers of lottery tickets. But, the market has now entered Stage 2 – the “digesting gains” stage. This is no longer a market in which every dip will be perceived as a new buying opportunity, because any dip now could bring on a long-awaited correction. In order for the market to experience a correction at Stage 4, it must first reach stage 3. The S&P 500 is currently at a level at which Stage 3 is within reach this week; that’s something that hasn’t occurred in a long, long time; and it may be just around the corner.

Stocks and Options at a Glance

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 2

Click Here for a complete chart of all Options Market Stages

Lottery fever began infecting the stock market on March 1, 2013 when Long Straddle trading became profitable, and that marked the beginning of Bull Market Stage 1. Stage 1 then continued nearly uninterrupted, with only a brief movement to Stage 2 during the pullback in stock prices this past June.

The current lack of profitability of Long Straddle trading is an indication that traders are no longer pushing stock prices up at the incredibly fast rate that they were earlier this year. For now, that is not terribly concerning, because Long Call trading and Covered Call trading are still profitable, and each of those is an indication that the long-term trend remains upward. Furthermore, the fast pace of rising stock prices was simply unsustainable, so a break would do the market good at this point. The problem is: the market does not always digest its gains in an orderly fashion. Digesting gains sometimes leads to an all-out correction, and in extreme cases, a bear market.

Preparing for What Will Happen Next

For the upcoming week (ending August 24, 2013) the market will start the week at Stage 2 – the “digesting gains” stage. Stage 2 will continue as long as the S&P closes the week between 1660 and 1705. Since the S&P is currently at 1656, that means that if stock prices do not recover some of last week’s losses this week, and if the S&P ends the week below 1660, Long Call trading will join Long Straddle trading in being unprofitable and Stage 3 will begin.

The loss of profitability of Long Call trading is another important landmark. It marks a significant weakening in the confidence of bullish traders. Even if the market subsequently rallies after reaching Stage 3, the bulls often lack the confidence to sustain the rally. Stage 3 is the “resistance” stage, marking the point at which recent market highs tend to become brick-wall resistance. If Stage 3 is confirmed this week, the market would likely find it difficult in the future to push the S&P past the record high reached earlier this August. Since the market has lost a lot of momentum, and trader’s confidence along with it, once it has reached Stage 3 many traders who bought stocks at those record highs would be happy to dump them if the market rallied enough for them to break even. Those sellers, and the selling pressure they provide, is what would create resistance if the S&P somehow managed to re-test those record highs.

For the first time in a long time, Stage 4 is not out of the question this week. If the S&P closes the week below 1609, Stage 4 – the “correction” stage will be confirmed. Stage 4 represents extreme losses on Long Straddle trading. Such losses generally result in a breakout, in which the market moves into an entirely new trading range. In a bull market, such as the current one, these breakouts tend to be to lower prices, and often represent the final sell-off of a correction.

Sometimes a correction is just a correction; and other times it is something much, much worse – the beginning of a bear market. As long as the S&P does not fall so far that Covered Call trading becomes unprofitable, it is usually just a correction and nothing more. For the upcoming week, Covered Call trading will remain profitable as long as the S&P remains above 1569. It can be inferred that anything above 1569 this week represents a bull market, anything below makes a strong case that it’s a bear market.

To summarize the options market stages for the week ending August 24, 2013:

  • S&P over 1705 indicates a return to lottery fever.
  • S&P between 1660 and 1705 indicates the market is continuing digesting gains.
  • S&P between 1609 and 1660 indicates recent highs may become strong resistance in the future.
  • S&P between 1569 and 1609 indicates a correction is underway.
  • S&P under 1569 indicates the presence of 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.

 Long 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 1569 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 1660, 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

The LSSI currently stands at -1.4%, which is significant, since it represents a decrease in the rate of the current uptrend in stock prices; and that is something that has been rare so far in 2013. For much of the year to date, Long Straddle trading has been unusually profitable. Losses on Long Straddle trades are historically common, and normal, so long as those losses do not fall below -6%.

A level of the S&P of 1609 this coming week would push the LSSI near -6% signaling that the market was “Due for a Breakout”. When such a level is reached in a longer-term bull market, such as the current one, it can mark an important turning point. Either stock prices break out higher, ending the pullback, or they break out lower and confirm that a more significant pullback – a correction – is underway. 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!”

Related Options Posts:

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Covered Call Trading Tells When To Buy The Dip

Options: Far Off Bear Market Is Sneaking Up

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