By Chris Ebert

Stocks and Options at a Glance

In last week’s Option Index Update it was noted that:

The emotions are overwhelmingly bullish. Of course that’s not a guarantee that the market will soar if news of a deal in Washington acts as a catalyst. While there is no way to predict the future with certainty, the current emotions portrayed by the performance of stock option trades suggests that such news would tend to favor a bullish move over the coming weeks, even if the initial reaction ends up being a sell-the-news event.

This week, emotions are currently as bullish as they get. Unless some truly disturbing economic news rocks the market, traders are likely to attempt to push the S&P 500 higher.

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 1

Most of 2013 has been spent at Stage 1 – the “lottery fever” stage. While the reasons for such a long stretch of nearly uninterrupted bullish strength are debatable, such as the effect of Quantitative Easing, the presence of this bullishness is not debatable. Traders as a collective group want to drive stock prices higher.

Bullish emotions are evident in the performance of option trades:

  • Covered Calls (Category A) trades are profitable, as they are in any market except a Bear market.
    So, they get a grade of A+.
  • Long Calls (Category B) trades are profitable, as they are in a strong Bull market.
    So, they get a grade of B+.
  • Long Straddles (Category C) trades are profitable, which only happens in the strongest Bull markets.
    So, they get a grade of C+.

The combined grade of the 3 strategies is currently A+ B+ C+, which is the definition of Bull Market Stage 1. For a complete description of all Option Market Stages click here.

What Happens Next?

Bull Market Stage 1 has its limits. Stock prices can only rise so fast before traders start to feel uneasy. If the S&P rises too quickly for traders’ comfort, the feeling of an “overbought” market can induce a Bull-market correction. The following chart depicts the limits of all Option Market Stages for the year 2013.

It can be seen that “lottery fever” has a distinct upper limit, and the market tends to correct rather quickly when that limit is violated, although the pullback in prices is not always large enough to fit the technical definition of a true correction. While this chart shows the tendency of Stage 1 to correct when it exceeded its upper limit in 2013, the chart of the LSSI that follows shows this tendency going back 10 years.

Options Market Stages Full Year 2013

It can be inferred from the chart that the S&P could potentially reach into the mid-1800s through the remainder of 2013 without setting off a correction. That does not, however, imply that something else won’t come along to set off a correction. What it does imply is that those who would start yelling for a correction, simply because the S&P reached 1800-something, are likely to be unjustified unless they have some other form of evidence to support their opinion.

Should stock prices pullback for whatever reason, the bar has been set quite high for the Bulls. As can be seen on the chart, it would not take much, for example a pullback into the low 1600s on the S&P in November, to be considered Bearish. That’s something to watch out for. It has been a long time since the Bears had any real control, and should they manage to take over again, even for a short time, they are likely going to make it worthwhile.

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 past 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 1582 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

Long Call trading has been profitable for most of 2013 except for a brief break from August through early October. The break in that historically long streak of profitability marked an important shift in bullish confidence; the Bulls lost the strength they had earlier in the year. This was evident in the recent failed attempt to break the 1710 weekly-close record on the S&P. The Bulls have since gained confidence, as revealed by the return of profits on Long Call trading, which allowed the S&P to break out to new highs. Only if the S&P closes the upcoming week below 1681 will Long Calls fail to profit, suggesting the Bulls have lost 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 +1.2%, which is normal. Such levels suggest that option traders have had a good handle on predicting the future. Excessive profits, such as those exceeding 4%, will not occur this coming week unless the S&P exceeds 1796. Anything higher than that is likely to result in some selling pressure, and historically has been associated with Bull-market corrections. 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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