By Chris Ebert
Stocks and Options at a Glance
The stock market will very likely behave much differently in the coming weeks than it has for a long, long time. That is because the current Bull market has lost momentum. In fact, momentum is so slow that there is barely any trend at all when one considers the movement of the S&P 500 over a period of several months.
Upward momentum has slowed to a pace at which Long Call option trading* is no longer profitable, and that is the first time the strategy has failed to profit since January 2013. Although the loss of momentum does not necessarily indicate that the longer-term bull market is coming to an end, it does have significant consequences. The end of the recent streak of profitability of Long Call trading indicates that the stock market has entered Bull Market Stage 3 – the “resistance” stage.
*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 3
Bull Market Stage 3 is known here as the resistance stage because once the market has entered this stage, recent market highs tend to become strong resistance if those levels are reached in the future.
It wasn’t all that long ago that the S&P was above 1700 and the Dow was over 15,600. For nearly all of 2013 stock prices have had upward momentum, and any pullback was followed by a rally which topped the previous highs. Sellers taking their profits at peak prices were met with ample buyers looking to cash in on the persistent upward momentum. But, now that the momentum has disappeared, traders are likely to be much more wary of buying stocks if the Dow and the S&P reach those levels again.
It is not impossible for stocks to set new records in upcoming weeks, but history has shown that such records do not come easily once Stage 3 has been reached. A rally back to those levels, if there is one, would likely stall at or near the record levels set several weeks ago. The stall is sometimes temporary. But there is a tendency for sellers to dump more stock at those levels than buyers are willing to purchase; and the result is often a significant pullback.
Preparing for What Will Happen Next
Bull Market Stage 3, while it represents a huge shift in emotions from the previous Stage 2, is itself not a big concern. It is, after all, still a Bull market. As such, it would not be surprising for stock prices to rally back towards the highs of August 2013, or at least toward the May 2013 highs since they are an easier target.
The danger in Stage 3 is that despite the possibility that prices may continue to rally, it can instead evolve into Stage 4 – the “correction stage”. Since every Bear market begins as a correction, the evolution from Stage 3 resistance to a Stage 4 correction is particularly concerning. Corrections can be healthy, but when they take a turn for the worse, a Bear market can reveal itself very quickly, sometimes in a matter of a few days or weeks.
For the upcoming week, ending September 7, 2013, Long Call trading will remain unprofitable unless the S&P 500 rises above 1711. If that were to happen, it would indicate a reversion back to Stage 2. It is interesting to note that 1711 would represent a new all-time high.
If new highs are not reached this week, Stage 3 will continue; and since new highs are improbable during stage 3, it would be very unlikely for the market to revert to Stage 2. Perhaps more probable is the possibility of progressing to Stage 4. If Long Straddle trading experiences extreme losses, beyond the historically significant limit of -6%, then Stage 4 could begin this week, and that would occur if the S&P falls below 1657. Since the S&P is already below 1657, it must rise this week in order to prevent the market from entering a Stage 4 correction. Thus, the most important question to be answered by the market this week is likely to be whether the S&P can stave off correction by rallying to at least 1657.
Once Stage 4 is reached, the market generally tests for a bottom – a support level at which buyers looking for bargains outweigh nervous sellers. A logical level of support when a market is experiencing a correction is a level that separates a Bull market from a Bear market. Since Covered Call trading has been an historically good indicator of the dividing line between bullishness and bearishness – profits signaling control by the Bulls and losses signaling that the Bears are in control – a market in correction often tends to seek out that line in order to test it. When a market is in the midst of a correction, there is nothing as precious to traders as confirmation that a support level will hold up when tested.
For the upcoming week, the dividing line between profits and losses on Covered Call trading is at S&P 1620. The worst case for the upcoming week would be for Covered Call trading to lose profitability, which would occur if the S&P fell below 1620, since that would be a strong indication of a bearish environment. But if the S&P finds support at 1620 it would be a strong indication that the Bull market would be expected to resume.
To summarize the Options Market Stages for the upcoming week ending August 31, 2013:
- S&P over 1757 indicates a return to Stage 1 lottery fever.
- S&P between 1711 and 1757 indicates a return to Stage 2 digesting gains.
- S&P between 1657 and 1711 indicates continuation of Stage 3 resistance.
- S&P between 1620 and 1657 indicates a Stage 4 correction is underway.
- S&P under 1620 indicates the presence of a Stage 5 Bear Market.
- S&P bouncing off 1620 is a strong Bull Market Stage 5 all clear signal.
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 1620 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 both became unprofitable for the first time since February 1, 2013. The break in that historically long streak of profitability marks an important shift in bullish confidence. Only if the S&P closes the upcoming week above 1711 will the Bulls will regain 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 -5.5%, 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 1657 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!”
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