By Chris Ebert

ASML traders are likely to not just feel bullish, but strongly bullish. However, an analysis of stock options reveals that those emotions are currently unjustified. The price of ASML shares is due for a correction. While the recent pullback from the $59 level may have satisfied some traders who believed the stock was overbought, a pullback to the $55.25 level would be even better. While it is true that price corrections occasionally evolve into outright selloffs, a healthy correction to $55.25 now would likely result in a continuation of the strong uptrend of recent months. For now, any pullback in ASML would appear to represent a buying opportunity.

Option premiums are determined by implied volatility, which is just a fancy way of saying that emotions determine whether or not option trades are profitable. The profit or loss of option trades can therefore reveal the emotions of traders. If the emotions are known, the decision of when to buy or sell a stock can be made with more confidence. A study of stock options can therefore be helpful, even for traders who do not trade options or understand how they function.

  • Covered call performance reveals whether traders fell bullish or bearish
  • Long call performance reveals whether traders feel a stock is strong or weak
  • Long straddle performance reveals whether traders feel surprised

Covered call options are best known as income-producing trades. Since they generate income, they only result in losses when traders of a stock are bearish – when the income is insufficient to offset the decline in the underlying share price. Covered calls opened 112 days before expiration react quickly to changes in a trend while smoothing out weekly swings that have little effect on the overall trend. At-the-money covered calls on ASML are currently profitable, when opened 112 days before expiration; therefore traders are likely to feel bullish.

The strength of bullish emotions can be determined by a different type of option trade, the long call. When an underlying stock price rises fast enough to overcome the premium required to purchase an at-the-money call option, 112 days before its expiration, traders are likely to feel confident in the strength of the stock. Long call options on ASML are currently profitable; therefore traders are likely to feel confident in the strength of the stock.

Regardless of covered call performance indicating bullishness, and long call performance indicating strength, it is possible for trader’s emotions to be unjustified. Traders sometimes remain bullish when a stock may actually be headed for a correction or worse, a breakout to a lower trading range. This condition can be measured by another type of option trade, the long straddle.

A long straddle is an expensive trade to open, since it requires the purchase of both an at-the-money call and put option. The high expense tends to greatly reduce any profits. When such a trade, opened 112 days before expiration, results in a profit of more than 4% it is an indication that traders were taken by surprise – the stock price moved more than most of them expected. This can be a dangerous condition because the stock price has come too far, too fast, to make traders comfortable, and often results in a correction.

When a long straddle results in a loss of more than 6%, it is also an indication that traders were taken by surprise – most expected the stock to move and it didn’t. This also represents a dangerous condition because traders are then likely to drive the stock to make a big move, but the direction of the move is often not easily predictable. A 112-day Long Straddle loss exceeding 6% often precedes a breakout below support that either confirms trader’s prior fears or a breakout above resistance that completely puts those fears to rest.

Straddles on ASML are currently generating profits in excess of 4%, indicating that the stock price is due for a correction. This does not necessarily mean that a correction is imminent, only that the recent movement in the stock price is likely to make traders feel ready for a correction. A correction over the next week or so, if the stock pulls back to $55.25 or lower, would satisfy those traders and the uptrend could then resume in a more normal, healthy trading environment. If the price instead resumes the uptrend without having pulled back to $55.25, an eventual correction in the future could be more drastic. Delayed corrections tend to evolve into a condition in which the stock not only corrects, but also breaks out below support levels, setting the stage for a bearish trend.

Option position returns are extrapolated from historical data that, while reliable, cannot be guaranteed accurate. It is not possible to match the exact performances shown, because the strike prices and expiration dates used in the calculations will not always be available in actual trading.

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 bookShow Me Your Options”.

 

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