By Chris Ebert
It is often possible to tell what the weather is, simply by looking out of a window. If folks are bundled in heavy jackets, it’s probably cold outside. If everyone’s in their shirt sleeves or short pants, then chances are good that it’s warm.
The stock market environment can be determined the same way, except that instead of clothing, stock traders use stock options for protection. Some stock options are like heavy jackets, while others are like short pants. A quick look at those stock options will reveal a great deal about the stock market environment.
Although it is an oversimplification, traders buy Put options when the stock market is cooling off, and Call options when things are heating up. So, Puts are like heavy jackets while Calls are like short pants.
Of course, the stock market is not so simple. Still, it is possible to obtain insight from such an oversimplification. That’s because it does not matter whether traders are buying Calls or buying Puts. What matters is how comfortable traders end up being in those positions. After all, people can choose to go outside in a snowstorm in their shirt sleeves. It is how comfortable those folks are in their choice of outdoor clothing that allows their indoor observer to tell the weather.
If Put buyers are displaying widespread comfort (in their heavy jackets) then it’s probably a Bear market. However, options don’t exist in a vacuum; for every Put buyer there is a Put seller. If Put buyers are comfortable, then Put sellers, especially Naked Put sellers, must be very uncomfortable.
The comfort of Naked Put sellers is just the beginning of what will be revealed in this weekend’s options analysis.
*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)
An Option Trader’s Wardrobe
One can determine whether or not it is a Bear market by observing either the comfort of Put buyers or the misery of Naked Put sellers. Quite simply, Long Put profits indicate a Bear market while Naked Put profits suggest it’s a Bull market.
The same logic can be applied to Call options. When Call buyers across a broad array of stocks experience comfort (presumably in their short pants) then it’s likely a hot Bull market, which should make Naked Call sellers very uncomfortable. In other words, Long Call profits show bullish strength, while Naked Call profits show weakness.
To extend that same logic one final step further, one may observe those option traders who buy Calls and also Puts. The combination of options is commonly known as a Long Straddle. This is somewhat analogous to wearing a heavy jacket with short pants, in essence preparing for a snowstorm or a summer-like day at the same time.
While many days it may be possible for someone dressing in such a manner to find comfort, there will also be days when it is just too warm for a heavy jacket and too cold for short pants. When this happens in the stock market – when Long Straddle traders are really uncomfortable – it is a signal that the market is undergoing a correction. Stated another way, large Long Straddle losses suggest that a correction is underway.
It isn’t terribly complicated, to understand why a large loss on a Long Straddle would be indicative of a market correction. It all has to do with the absence of a trend. If there was a Bull market underway, Long Straddle losses can only occur when the uptrend has disappeared for an extended period. It’s the same for a Bear market except that Long Straddle losses follow a disappearance of the downtrend. Usually this occurs when the pace of the trend has become unsustainable, thus requiring a correction to make the pace more reasonable. If the correction brings prices back to where they were several months earlier, the overall trend disappears, which is a recipe for large losses on Long Straddle trades.
As it turns out, a loss of approximately 6% (calculated at expiration, as a percentage of the underlying price) can be considered a rather large loss for a Long Straddle, if it was opened at-the-money 4 months prior to expiration. It follows that a 6% loss on such a Long Straddle, in which the S&P 500 or its equivalent serves as the underlying, would indicate that the S&P 500 was undergoing a correction.
You are here – Bull Market Stage 4.
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 2.9%.
- Long Call trading is currently not profitable (B-). This week’s loss was -3.0%.
- Long Straddle trading is not currently profitable (C-). This week’s loss was -5.9%.
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. However, the fact that losses from Long Straddle trading were excessive, nearing 6%, makes Bull Market Stage 4 a more accurate portrayal of the market. That means the S&P has not just encountered strong resistance at Stage 3, as it has done in previous weeks when it failed to hold above the 1880 level, it is now experiencing a Bull-market correction for the first time since 2012. For a description of Stage 4, as well as a comparison to all of the other stages, the following chart is provided:
As can be seen on the chart above, Stage 4 tends to be an environment in which Covered Calls and Naked Puts either break even or return small losses after an extended period of profitability. The current period of profitability extends, in a nearly unbroken streak, all the way back to 2011, so a sudden loss of profitability would be a big deal.
While Covered Calls and Naked Puts did remain profitable this past week, if the current correction proceeds as many have proceeded in the past, there is a good chance that stock prices may fall far enough to test whether the current Bull market is intact. Since the profitability of Covered Calls and Naked Puts is a strong indication of a Bull market, to test the limit of the current Bull market would mean testing the dividing line between profits and losses on those Covered Calls and Naked Puts.
As can be seen on the following chart, the dividing line between a Bull market and a Bear market is the red line, which coincides with the dividing line between profits and losses for Covered Call trading and also Naked Put trading. Above the red line it’s shirt sleeves, below it it’s heavy jackets that are comfortable.
A healthy Bull market would be expected to experience a bounce in stock prices at, or near, the red line over the next few weeks. Since the red line is currently at approximately the 1790 level on the S&P 500, a bounce higher from the 1790 area would be a welcome sign for the Bulls. There is no guarantee that the S&P will sink to the 1790 level, but if it does, the presence of support, or lack thereof, could affect the market for many weeks or months.
In the event that stock prices decline enough to bring the S&P 500 below the 1790 level without recovering before the end of the coming week, it would be a strong indication that a new Bear market had begun. If so, it will be recognizable by the abundance of traders suddenly comfortable with their Long Puts (heavy jackets) for the first time since 2011.
Weekly 3-Step Options Analysis:
It is often helpful to see the analysis from a different frame of reference. For a more in-depth examination of the Options Market Stages, the following 3-Step analysis is provided.
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 1791 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 1892 would be a sign of 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 -5.9%, which is very near the level of 6% normally considered excessive. Such 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 1942. While nothing in the stock market is impossible, reaching 1942 this coming week is highly unlikely. The S&P exceeding that level this upcoming week would indicate that Bull market of 2013 was once again underway and the recent correction 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 2016. Despite the presence of euphoria if the S&P was to reach that level, anything higher than 2016 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, 2016 is almost certainly out of reach 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 1832. At or near 1832 a subsequent breakout is likely. Since the S&P is already near that 1832 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 1791, it could be a very, very bearish signal, while a bounce higher from the 1791 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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