By Chris Ebert

The chart creates the news, and not t’other way around. It’s a remarkable concept, bound to stir fear in the heart of most any stock market participant. Fundamental stock market analysts, particularly, may be prone to proclaim such a claim as outrageous; and even technical analysts who live and die by-the-chart may be reluctant to consider it. Yet, denial doesn’t make such a concept untrue.

Essentially, the pattern that stock prices create (when plotted on a chart through the passage of time) is a determining factor in the very economic news that concerns the health of the companies and stocks themselves. The chart influences the news.

newsThe most obvious reason that such a concept may initially seem absurd is that stock prices do not determine corporate earnings. A company that is earning profits will generally continue to earn profits regardless of the stock price.

In fact, the entire basis of the stock market is that market participants are given the sole task of determining the fair prices of stocks; and those prices are based in large part on earnings – past earnings, current earnings and, most importantly, expectations for future earnings of the companies that issued the stocks.

It is easy to assume that it makes no difference whether a specific company’s stock is trading at $1 per share or $100 per share, the difference in stock price should have no direct bearing on the ability of the company to earn a profit. Indeed, employees may go to work at a company each day without the slightest care as to the price of the company-stock, or whether that price is going up, or down. Likewise, customers generally don’t care about the stock price, but rather the price of the product or service they are purchasing.

Employees are largely not likely to stop working because of a change in the stock price, nor are customers going to stop doing business. For each individual company, therefore, the stock price is of no real concern to employees or to customers, but only to the stockholders. Quite simply, the stock price is the stockholders’ problem and nobody else’s – at least that’s a common assumption. There’s just one thing; the assumption is flawed.

Stock Prices Do Influence Corporate Profits

In order for stock-price not to influence corporate earnings, a company would have to operate in a vacuum. Since the health of individual companies depends in large part on the health of the overall economy, and since broad changes in stock prices can affect the overall economy, the stock market itself can often be a factor in determining corporate profits.

Stock prices can and do affect corporate profits. It’s like the old saying “A rising tide raises all ships”. If the overall economy is roaring, it bodes well for the future earnings of individual companies. Most companies can expect to sell more products and services when the overall economy is doing well than when it is struggling. In short, folks buy more goods and services when the stock market is broadly healthy.ship

Even though the stock market is not the economy, and the economy is not the stock market, the two are inextricably related. Each one affects the other, and the effect on the second then influences the first.

Economic expansion is, not surprisingly, most likely when the stock market is doing well. Economic recession, by contrast, tends to occur when consumers lack confidence, as often occurs when the stock market is performing poorly. Viewed in that light, a rallying stock market favors economic expansion; a declining stock market favors recession. Rising stock prices bode well for up-trending corporate profits, not only for the broad market but for individual companies within the market; falling stock prices do not.

Even the best companies, with the best products and services, will suffer when a downturn ensues in the overall economy. Corporate profits, even for the strongest companies, tend to decline when the economy as a whole contracts. Declining profits, especially prospects of further declines, lead investors to settle upon lower stock prices, even for the strongest of companies, when the economy is contracting.

Stock buyers just are not willing to pay as much for a share of a strong and vibrant company if the overall economic conditions are a mess. Stock sellers must either accept what a buyer is willing to pay, even if it is a lower price than they prefer, or else risk not making the sale. The process can quickly become self-sustaining due to the effects of forcing.

Forcing occurs when something moves in one direction and is then forced further in that same direction as a side-effect of the initial move. When stock prices broadly decline, folks become less confident, consumers spend less on products or services, which leads to declining corporate profits. The decline in profits, and the prospect for further declines, forces stock prices to decline further – in the direction they were already headed – and the process then repeats in a vicious cycle.

The Stock Market Cycle

Through judicious intervention by large entities, such as governments or central banks, the effects of forcing can be altered. However, once the stock market has reached a tipping point, it is unlikely that any amount of intervention can overcome the effects of forcing. Once the stock market has reached a point in its cycle that favors declining stock prices, no amount of economic stimulus can prevent the progression of the cycle.

The cycle – of rising corporate profits, stock price increases, stock price decreases and ultimately of declining corporate profits – can be manipulated. But, it presumably cannot be stopped altogether. The normal stock market cycle is what ultimately determines the health of the economy of every nation on Earth. Since all the economies of the world are now connected to some degree, every nation is now vulnerable to the effects of the cycle in all the surrounding economies.

No nation’s economy is entirely immune to the progression of the normal stock market cycle, because no amount of intervention by any single government or by any single central bank is likely to ward off the progression of the cycle in other parts of the world. Even when large coalitions of nations combine their efforts, the progression of the stock market cycle in areas not under the jurisdiction of the coalition will ultimately be felt.

reaganThe most a large coalition can hope for, for example, the U.S. Federal Reserve (the “Fed”), the European Central Bank (ECB), or the Bank of Japan (BoJ) is to postpone the inevitable. Even then, postponement may or may not be beneficial since the ultimate progression of the cycle may lead to more severe consequences for the economy than would have been realized had the cycle been allowed to progress normally, without intervention. Even when such powerful entities join forces, their efforts tend to be powerless against the eventual progression of the normal cycle. The combination of the ECB, the European Commission (EC) and the International Monetary Fund (IMF), known collectively as “the Troika”, has struggled to intervene in the progression of the stock market cycle in the European Union for many years, with results that are debatable.

Reaganomics, Clintonomics, the Troubled Asset Relief Program (TARP), Abenomics, Quantitative Easing (QE), European QE (Q €) are among some of the more recent examples of programs designed to thwart the normal progression of the stock market cycle. Whether any of those programs do more harm than good for the long-term economy – whether they sacrifice future prosperity to avoid near-term suffering – is the source of ongoing deliberation between the so-called Keynesian and Austrian theories of economics.

Although these schools of thought differ in their belief in whether intervention in the economic cycle is prudent, one thing that they do have in common is that the economic cycle exists. And, since the economy is inextricably linked to the stock market, the stock market cycle ultimately determines the health of every economy in the world. The stock market cycle thus is the ultimate generator of economic news.

Earnings, losses, employment, expansion, recession, interest rates, stimulus, inflation, deflation, central-bank intervention: it’s all a result of the stock market cycle, not the cause of it. Corporate earnings, for example, are a direct result of the effect of the economic cycle, just as much as the timing of announcements regarding central-bank policy. The chart creates the news.

Each individual bit of economic news is little more than a reaction to the progression of the normal stock market cycle. Even though news can certainly have temporary effects on the stock market, and economic news can affect the chart, such effects are both fleeting and minimal when compared to the propensity for the news to be influenced by the stock market cycle. The news is influenced by the stock market cycle much more than it influences the cycle. Economic news is mostly a reaction to the chart, not t’other way around.

Unveiling the Stock Market Cycle through Options Analysis

The stock market cycle is perhaps most widely recognized by longer periods of bullishness (up-trends) punctuated by shorter periods of bearishness (down-trends). But, it’s much more complex than just Bull markets and Bear markets.

There are, of course, many different views of the stock market depending on the time frame of the observer. There are, for example, secondary Bear market trends that last several weeks or months within the confines of wider primary Bull market trends that may last several years or decades. Thus, due to the importance of the time frame, the stock market cycle may not be apparent to certain audiences, particularly if their specific time frame does not match the timing of the cycle itself.

Like any cycle, it is necessary to eliminate the importance of time in order to view the cycle clearly, or at the very least, reduce the viewer’s dependence on time. The simplest method for reducing the need to keep track of time is known as synchronization.

It works with everything from synchronizing the clock pulses of computer circuitry, to synchronizing a watch or an alarm clock to the time zone where the device is located, to the simple calendar hanging on the wall. As long as everyone is on the same page, synchronization allows individual events to be catalogued without the need to calculate the timing of the event.

Everyone knows when the first day of February begins, for example, so any event that occurs on February 1 is immediately perceptible to everyone using a standard calendar. If a television show begins at 6:30 P.M., there is no need to calculate the distance in time from another arbitrary event, for example, the time since sunrise, or the time since World War II ended, so long as one has access to a clock that is synchronized to the same time as the television network. When the opening theme plays, it comes as no surprised to everyone who is synchronized.stopwatch

The problem with synchronizing oneself to the stock market cycle is that there are an infinite number of possible methods for timing the events that occur in the market. Whereas it is simple to ask someone “Is the weather warmer today than yesterday?” it is not as simple to ask someone “Is the stock market more bullish today than yesterday?” That’s because everyone is synchronized to the same calendar and can easily distinguish today’s weather from yesterday’s. But, ones perception of bullishness or bearishness depends entirely on the time frame of the observer.

Independent Observers Must Detect an Identical Cycle

Since synchronization to the stock market cycle may never be possible, the only practical method for observing the stock market cycle, therefore, would seem to be to remove time from the equation entirely. If stock prices at one time can be compared to stock prices at another time, in a manner that does not depend on the time frame of the observer, then it certainly seems possible that the stock market cycle would be observable.

Such a method would require that any two observers, whether a day-trader looking at the change in stock price minute-by-minute or the long-term investor looking at the change in stock price over weeks, months or years, each come to the same conclusion. While it is possible that more than one such method exists, perhaps one of the best candidate for such an analysis is through a study of stock options.

Options are based upon the passage of time. Option prices are in fact determined by time itself. Therefore, an options trader sees the stock market without regard to time. An option trader does not say “Stock prices are higher today than yesterday” an option trader says, simply, “Stock prices are rising faster than expected, or slower than expected” The fact that prices are higher after an arbitrary passage of time (for example, one day) are practically meaningless to the option trader.

Options determine how fast a stock is traveling, not the distance it has traveled. The speed of an object is independent of the time frame of the observer. Thus, if one wants to know the speed of the stock market, option performance is an almost-perfect method of measurement.

If the speed of the stock market is plotted over a sufficient period of time, any cycle should become visible. Essentially, the stock market should change speeds as time passes. If a stock market cycle exists, the changes in speed should form a pattern. If the pattern is repeatable, then it should not only indicate changes in the speed of the stock market in the past, but also the most likely time for the stock market to change speed in the future.

Assuming options have the ability to predict changes in the speed of the stock market in the future (and the following analysis suggests that is a fair assumption) then it should also be possible to predict the most likely time frames for certain economic news to occur. After all, the stock market chart creates the news, not t’other way around.

Ebert Cycle

The following pattern has been presented here regularly for several years. It consists of just three simple option trades. When these trades are studied in regards to options on the S&P 500 index as a whole, the pattern tends to reveal the performance of the overall U.S. stock market, since the S&P 500 represents a large cross section of U.S. companies.

  • Covered Calls are profitable ==> Long Calls are profitable ==> Long Straddles are profitable

Eventually a Bull market will become overextended, and stock prices will fall back, in a process commonly known as a pullback or correction. It’s simply the above pattern in reverse.

  • Long Straddles are losers ==> Long Calls are losers ==> Covered Calls break even

This cycle of option profitability and loss is known as the Ebert cycle, named for option scientist and author, Christopher Ebert, who exposed it as the normal progression occurring in a healthy Bull market. Any deviation from the cycle is considered abnormal, and therefore brings the health of a Bull market into question.

In a healthy Bull market, the cycle repeats over and over again, and can theoretically continue indefinitely. Every time Covered Calls hit bottom – the point at which they break even – the Bull market cycle starts all over again. Covered Calls do not suffer losses during Bull markets. Thus, if at any point Covered Call trading results in losses, the normal Bull market cycle tends to be interrupted and a Bear market usually ensues.

To be clear, the normal Bull market cycle can be viewed as a series of Options Market Stages:

  • Stage 0 – Long Calls become profitable
  • Stage 1 – Long Straddles become profitable
  • Stage 2 – Long Straddles become losers
  • Stage 3 – Long Calls become losers
  • Stage 4 – Covered Calls break even
  • Stage 5 – Covered Calls become profitable

The normal progression in a Bull market is from Stage 0 to 5 then starting back at 0 again, at which point the cycle repeats indefinitely.

 ==> Stage 5 ==> Stage 0 ==> Stage 1 ==> Stage 2 ==> Stage 3 ==> Stage 4 ==> Stage 5 ==> Stage 0 ==>

While Covered Calls never suffer losses in a textbook version of a normal Bull market, Long Calls and Long Straddles each fluctuate between periods of profitability and periods of losses. The same progression shown above is also shown below, except that the Stages in which Covered Calls are profitable,  Long Calls are profitable and Long Straddles are profitable are each highlighted on separate lines below.

  • Options Market Stages in which Covered Calls are profitable:
==> Stage 5 ==> Stage 0 ==> Stage 1 ==> Stage 2 ==> Stage 3 ==> Stage 4 ==> Stage 5 ==> Stage 0 ==>
  • Options Market Stages in which Long Calls are profitable:
==> Stage 5 ==> Stage 0 ==> Stage 1 ==> Stage 2 ==> Stage 3 ==> Stage 4 ==> Stage 5 ==> Stage 0 ==>
  • Options Market Stage in which Long Straddles are profitable:
==> Stage 5 ==> Stage 0 ==> Stage 1 ==> Stage 2 ==> Stage 3 ==> Stage 4 ==> Stage 5 ==> Stage 0 ==>

As can be seen in the above progressions, the option strategy that most consistently varies between profit and loss during a Bull market is the Long Call. It stands to reason that a historical pattern of Long Call performance, particularly one that spans several years, would be the best choice to reveal the stock market cycle, if such a cycle indeed exists.

Covered Calls never suffer losses in a normal Bull market, so plotting the profit and loss of such trades is unlikely to reveal a stock market cycle. The same is true of Long Straddles, which do oscillate between periods of profit and loss, but not nearly as consistently as Long Calls. Long Calls are profitable in half of the six Bull Market Stages and suffer losses in the other half. Thus, if a stock market cycle exists, Long Call performance is the most logical choice to reveal it.

The #LCMPI – The Long Call/Married Put Index for the S&P 500

Long Call performance for the S&P 500 as a whole, specifically the performance, at expiration, of at-the-money (ATM) Long Calls opened 4-months to expiration, is routinely published here as part of the S&P 500 Long Call/Married Put Index, or #LCMPI. The following chart shows the performance of Long Calls each week for the past ten years as would be experienced on a broad-market Exchange Traded Fund (ETF) such as the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) or $SPY.

LCMPI 01-31-15

A rather glaring pattern appears on the chart, a narrowing formation in which Long Call performance tends to vary less and less as time progresses. The variation of Long Call performance from profit to loss, and back to profit again is the bullish stock market cycle.

Long Calls, during a normal Bull market, undergo periods of profit and loss that correspond with periods of bullish strength and weakness, respectively. However, the pattern narrows over time. Eventually, all Bull markets reach a point at which the oscillation, even at its highest point, no longer represents bullish strength. A Bull market ends when there is no longer any possibility of showing its strength.

The diminishing prospects for bullish strength may not be perceptible to traders. It is possible for traders to sense something changing in the stock market without actually being able to describe the nature of that sense. The stock market cycle, as revealed by the #LCMPI can help traders quantify the sense of diminishing prospects.

Moreover, once the prospects for bullish strength have diminished to near zero, it is a very opportune time for a Bear market to begin. While there is no absence of Perma-Bears, those who scream “the sky is falling” during every pullback in the S&P 500, there is certainly a case for traders to fear a bearish environment in the near future.

Stock Market Cycle

The prospects for bullish strength are clearly diminishing as time passes. If the stock market cycle continues, those prospects will be near zero sometime in 2015. Obviously, the pattern, as it exists now, is unsustainable. The #LCMPI cannot simply decrease to zero and remain there. For, if the #LCMPI goes to zero, bullish confidence will disappear from the market and stock prices will tumble, which would drag the #LCMPI lower.

Predictions for 2015 Based on the #LCMPI

Perhaps the most provocative implication from the chart of the #LCMPI is that, because the current stock market cycle absolutely must be interrupted in 2015 – because the #LCMPI cannot converge to zero and remain there – there will almost certainly be major headlines that affect the stock market in 2015 like no other time in recent years.

One can speculate as to how the #LCMPI chart will resolve. Perhaps the chart will narrow to zero, prospects for bullish strength will go to zero as well, and the first Bear market in several years will ensue.

It is also possible that the lines will cross, forming an “X” and the #LCMPI will then go on to form a broadening formation later in 2015, and that could signal the start of a brand new Bull market. Even so, for the lines to cross, there will come a point at which the #LCMPI reaches zero, and when it does, things could get very bearish, very fast, even if such an environment is only temporary.

Whatever the outcome, given the current progression of the stock market cycle, the year 2015 appears to be setting itself up as a year of very high risk in the stock market. Since the stock market cycle causes the headlines, and not t’other way around, 2015 is a year that is likely to generate more intense economic headlines than any year since at least 2008.

Whether the Fed chooses to use its power in attempt to interrupt the current trajectory of the #LCMPI, for example, or whether the trajectory of the #LCMPI forces the Fed to initiate policy changes in 2015 remains to be seen. Whether the converging pattern in the #LCMPI causes corporate earnings to fall in 2015, or whether the eventual divergence of the #LCMPI into a broadening formation causes corporate earnings to rise in 2015 is also a matter for debate. What is less debatable is that the #LCMPI is the root cause. The chart causes the news.

Stocks and Options at a Glance 01-31-15

* All profits are calculated at expiration, as a percentage of the underlying SPY share price. SPY is an Exchange Traded Fund (ETF), the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) that closely tracks the performance of the S&P 500 stock index. All options are at-the-money (ATM) when-opened 4 months (112 days) to expiration.
EXAMPLE: If Long Call premium paid is $2 when SPY is trading at $200, the loss is 1% if the option expires worthless.

You are here – Bull Market Stage 2 – the “Digesting Gains” stage.

On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending January 24, 2015, this is how the trades performed on the S&P 500 index ($SPY or $SPX):

  • Covered Call and Naked Put trading are each currently profitable (A+).
    This week’s profit was +4.7%.
  • Long Call and Married Put trading are each currently profitable (B+).
    This week’s profit was +0.0%.
  • Long Straddle and Strangle trading is currently not profitable (C-).
    This week’s loss was -4.7%.
Options Market Stages

Click on chart to enlarge

The combination A+ B+ C- occurs whenever the stock market is at Bull Market Stage 2, the “Digesting Gains” stage, which gets its name from the tendency of stock prices to experience strong rallies punctuated by relatively minor pullbacks or consolidation, the breaks in the uptrend being the market’s way of digesting each successive gain.

The chart above shows the general market environment for Stage 2 in comparison to all of the 11 Options Market Stages. The chart below depicts the progression of the S&P 500 through the Options Market Stages over the past year.

OMS 01-31-15


The following weekly 10-minute 3-step process provides further analysis.

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, which balances sluggish responses of longer expirations with irrelevant noisy responses of shorter expirations.

 CCNPI 01-31-15

Historically, any time Covered Call trading has become unprofitable, a full-fledged Bear market has ensued within a few weeks to, at most, a few months. That makes the recent October 2014 dip into unprofitability, the first such instance in 3 years for Covered Calls, a major signal for the potential of an upcoming Bear market within the following four months… through approximately the end of February 2015. As bullish as the current market may appear, traders should be open to the possibility that a Bear market is certainly not impossible.

The unprofitability of Covered Call trading does not guarantee that a Bear market will occur soon, nor does it imply that stock prices cannot rally much higher in coming weeks. Rather, it indicates that similar conditions as currently exist have always resulted in Bear markets in the past. Traders should be prepared for the possibility any rally is a trap. Even if it turns out not to be a trap, it is better to be safe than sorry.

If the S&P falls below 1795 over the upcoming week, Covered Call trading (and Naked Put trading) will become un-profitable, indicating that the Bears have regained control of the longer-term trend. Above S&P 1795 this week, Covered Calls and Naked Puts would be profitable, which is normally a sign that the Bulls are in control. However, such control is usually only temporary as long as the Bulls lack strength and confidence.

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 which balances sluggish responses of longer expirations with irrelevant noisy responses of shorter expirations.

 LCMPI 01-31-15

Long Call trading losses ensued several weeks ago, a major sign of a lack of bullish confidence and strength. While Long Call losses by themselves are not a sign that the Bears have taken control, the loss of confidence that occurs when Long Call trading is unprofitable can quickly reveal underlying bearish tendencies unless a sustained rally occurs within a few weeks.

Once Long Call losses are occurring, a propensity for profit-taking often sweeps over market participants – a propensity that generally lasts for at least several weeks. If a Bull market can endure this propensity without suffering a major correction, it can be strong indicator of future growth in stock prices. A market with bearish tendencies, however, can rarely endure the added burden of a widespread propensity for profit-taking, at least not without suffering a major pullback or correction.

Long Call profits returned two weeks ago and remained profitable (barely) this past week. But, it could take several weeks of Long Call profitability before the propensity for “selling the rip” disappears. If Long Call losses return in the next few weeks, before the propensity to sell-the-rip has had time to fade, the lack of confidence could quickly reveal itself as an outright propensity to sell at any price, not just to sell-the-rip. That’s a dangerous quality, because in the absence of a significant confidence-boosting event, a propensity to sell is at the root of all Bear markets.

If the S&P manages to close the upcoming week above 1978, Long Calls (and Married Puts) will retain profitability, suggesting the Bulls have retained confidence and strength. Levels above 1978 would suggest a continuation of recent sentiment, notably confidence by the Bulls. Below 1978, weakness and a lack of confidence should be abundantly apparent.

Confidence and strength show up as a “buy the dip” mentality, while a lack of confidence and strength produces a “sell the rip” sentiment that tends to create brick-wall resistance, since each high is perceived as a rip to be sold. In a true Bear market, the Bulls will never be confident and strong; thus, Long Calls and Married Puts will never profit during a Bear market. Profits are therefore compelling evidence that the Bulls are firmly in control.

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 Either 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, which balances sluggish responses of longer expirations with irrelevant noisy responses of shorter expirations.

 LSSI 01-31-15a

The LSSI currently stands at -4.7%, which is abnormally low and nearing a level of concern, as it is indicative of a market that has become overly range-bound (and therefore nearing a level at which it is “due for a breakout” from the range of the past few months.

Range-bound markets tend to demand a breakout in prices from the range of the past several months. A breakout can always occur for other reasons, for example surprising economic news. But a breakout can also occur for seemingly no reason at all, other than the fact that traders have become anxious due to several months of range-bound stock prices. Currently, a breakout is becoming more likely to occur on its own accord, perhaps even without any sufficient news catalyst, because the LSSI is becoming abnormally low. An LSSI below -6.0% is considered extreme.

Over-extended markets tend to demand a correction, at least temporarily. A correction can occur for other reasons, such as a news catalyst, but can occur without any catalyst at all when the LSSI is abnormally high. Currently, no correction is likely to occur of its own accord, without a significant news catalyst, because the LSSI is not abnormally high. An LSSI above +4.0% is considered extreme.

The 3 unusual conditions for a Long Straddle or Long Strangle trade are:

  • Any profit
  • Excessive profit (>4% per 4 months)
  • Excessive loss (>6% per 4 months)

Long Straddle trading (and Long Strangle trading) will become profitable during the upcoming week only if the S&P closes above 2093. Values above S&P 2093 could only occur during an irrationally exuberant Bull market. Values above 2112 would therefore suggest the presence of an overbought market, but sustainably overbought – as occurs during the Lottery Fever Stage.

Excessive Long Straddle trading profits (more than 4%) will not occur unless the S&P either exceeds 2172 this week. Values above 2172 can only occur in a roaring Bull market, but would suggest that stock prices have risen too far too fast for the rate to be sustainable, thus needing to correct lower, at least temporarily, in order to return to sustainability for the uptrend. 2172 therefore represents the extreme upper limit of the Lottery Fever Stage.

Excessive Long Straddle losses (more than 6%) will not occur unless the S&P moves to very near 1975 this week. Since excessive losses tend to coincide with a desire for traders to make stock prices break out, either higher or lower than the boundaries of their recent range, a level of the S&P near 1975 would likely bring a violent snap-back rally or else a violent resumption of the most recent downtrend. The 1975 level therefore divides an ordinary ‘pullback’ (above it) from a significant Bull-market ‘correction’ (below it).

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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