By Chris Ebert
The stock-options market is shouting a message from the rooftops this week: Be prepared for extremes!
The S&P 500 is currently stuck in no-man’s land – Bull Market Stage 3 – technically bullish, yet so weak that a significant pullback in stock prices is not out of the question. What’s more, it has now been stuck on this battlefield for about 4 months, since late December actually, with neither the Bulls nor the Bears making any clear progress toward a victory.
That time period – 4 months – is now becoming very important, because stalemates that have historically lasted that long have often ended with a major breakout in stock prices. Either stocks finally manage to break out above a level that has stood like a brick wall of resistance, or else they sink into a much lower trading range than has been experienced for several months.
*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)
Quite simply, the S&P 500, in spite of some big moves both up and down, has ended up here in late April just about where it was 4 months ago in late December – right around 1850. While the trend over the past 6 months to a year or more has been bullish, there has been significant weakening of that bullishness in recent weeks and months. In fact, the trend has weakened so substantially that Long Call* option trading has now become unprofitable.
You are here – Bull Market Stage 3.
On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending April 12, 2014, this is how the trades performed:
- • Covered Call trading is currently profitable (A+). This week’s profit was +3.0%.
- • Long Call trading is currently not profitable (B-). This week’s loss was -1.3%.
- • Long Straddle trading is not currently profitable (C-). This week’s loss was -4.3%.
Using the chart above, we can see that the combination, A+ B- C-, occurs whenever the stock market environment is currently at Bull Market Stage 3
As was mentioned here last week:
“Buying stocks when Long Calls fail to profit is tantamount to fighting the tides of the sea.”
Like a spouse looking to exit a marriage gone stale, stock owners have now endured about as long a time period as they are prepared to endure without divorcing their shares. If stocks don’t start making their owners really happy, really soon, then the divorce papers will be filed, and the market will be flooded with shares available to the highest bidder.
There is something important to consider when thinking about the highest bidder. Who wants to be that bidder when stock prices have basically gone nowhere for the past 4 months? Bidders in 2013 were easy to come by, since stock prices seemed to rise week after week. But, here in 2014 it is now a different story; one that has potential serious consequences.
If a lot of stock owners file for divorce, if they put up their shares for sale to the highest bidder because they have not been happy for 4 months, and there are few bidders willing to buy those shares, again because they have not made anyone happy for the past 4 months, those current stock owners will be forced to sell their shares at a much lower price. If such a scenario was to play out, stock prices could tumble.
How low could prices go? Well, this is technically still a Bull market; and while there are no guarantees, it is likely they would find support before things were to become terribly bearish.
As a rule of thumb, Bull markets never dip so far that Covered Call* trading becomes unprofitable. Currently, it is possible for the S&P to dip into the 1780s or 1790s without affecting Covered Call trading profits, so support in that range would be expected if there was a selloff. If the current Bull market remains intact, the S&P should not dip below the red line in the chart below. Any dip below the red line would be a decidedly bearish sign.
The following conclusion from last weekend’s update remains valid:
When Bull markets become weak, pullbacks can be both swift and severe, and they can occur with or without accompanying economic news. If a significant sell-off does indeed occur in the next few weeks, readers here may want to consider that the reason for such a sell-off may be nothing more than weakness, as evident in the S&P’s failure to climb any higher than Bull Market Stage 3 this past week.
If there is no major selloff over the next few weeks, then it would be quite logical for the Bulls to make another attempt to break through that brick wall of resistance near S&P 1880. As with past attempts, failure to break through can cause the S&P to decline sharply, perhaps as low as the red line in the chart above, while success would be expected to open up the possibility of S&P 2000 within a month or so, as it seeks out its upper limit near the green line.
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 did not experience a single loss in 2013, and the streak endures so far in 2014, continuing a streak of nearly lossless trading extending all the way back to late 2011. That means the Bulls have been in control since late 2011 and remain in control here in 2014. As long as the S&P remains above 1793 over the upcoming week, Covered Call trading (and Naked Put trading) will remain profitable, indicating that the Bulls 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 became unprofitable this past March, and those losses intensified during April. Losses for Long Calls are a sign of weakness for a Bull market. Such weakness can be dangerous because it lowers the perceived reward potential for stock owners, which makes stocks less attractive, in turn lowering the price stock sellers are able to obtain from buyers.
Failure of the S&P to close next week above 1887 would be a sign of continued weakness; and weakness always has the potential of putting downward pressure on stock prices. If the S&P fails to close the upcoming week above 1892, Long Calls (and Married Puts) will 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.
The LSSI currently stands at -4.3%, which is very near the level of 6% normally considered excessive. Such excessive levels have historically been followed by major breakouts in which the S&P moves out of the trading range of the past several months, and either soars to new highs or else makes lower lows than it has experienced for quite some time.
Profits on Long Straddle trades will not occur this coming week unless the S&P exceeds 1941. While nothing in the stock market is impossible, reaching 1941 this coming week is highly unlikely, as it would require a gain of approximately 80 points from the current level. In the unlikely event that the S&P exceeds that 1941 level this upcoming week, it would indicate that Bull market of 2013 was once again underway and the recent correction/consolidation was simply a pause in the uptrend.
Excessive profits on Long Straddle trades, such as those exceeding 4%, will not occur this coming week unless the S&P rises above 2014. Despite the presence of euphoria if the S&P was to reach that 2014 level, anything higher than 2014 this coming week would be absurd and would likely to result in some selling pressure. Historically, such absurd bullishness has been associated with subsequent pullbacks and, occasionally, Bull-market corrections. In any case, 2014 is almost certainly out of reach for the S&P this coming week.
Excessive losses on Long Straddle trades, such as those exceeding 6% will not occur this coming week unless the S&P nears 1830. At or near 1830 a subsequent breakout is likely. Since the S&P is currently not terribly far from that 1830 level, the chances of a major breakout are elevated now. As mentioned in Step 1, if a breakout brings about a lower trading range, especially below 1793, it could be a very, very bearish signal, while a bounce higher from the 1793 area would be a strong indicator that the market had put in a bottom, at least temporarily, at a level of strong support.
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.
The preceding is a post by Christopher Ebert, co-author of the popular option trading book “Show Me Your Options!” He uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. Questions about constructing a specific option trade, or option trading in general, may be entered in the comment section below, or emailed to OptionScientist@zentrader.ca
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