By Chris Ebert

One quality of the stock market that is universal is that folks tend to buy stocks when the reward appears to be better than the risk. So, simple as it may seem for something as complex as the stock market, there are really only two factors that cause stock prices to move: a change in the perceived reward, or a change in the perception of risk

There is a natural tendency for traders to scan the market for evidence of either increasing reward or increasing risk. Economic developments are often viewed only in terms of whether they are more likely to increase the reward or increase the risk to traders. In simplest terms, traders like to buy stocks when the reward increases, and sell them when the risk increases.

riskAn often-misunderstood quality of the market is that a decrease in reward can be perceived as an increase in risk, just as a decrease in risk can be perceived as in increase in the potential for reward.

Even though the two concepts, risk and reward, are not necessarily linked together, many traders do indeed combine them into a single concept. As such, risk can be viewed, not just as the potential for stock prices to fall, but for the absence of the potential for stock prices to rise; reward, in that light, reward is nothing more than the absence of risk.

Since it is not possible to know in advance the exact nature of future economic news, it is not possible to know whether the market will perceive such news as an increase in reward or an increase in risk. It is, however, possible to pinpoint specific levels on a chart that are likely to represent an absence of reward or an absence of risk.

So, while it will almost always be impossible to know which way the stock market will go tomorrow, because the news is not yet known, a trader can always make some assumptions about what effect the chart will have on stock prices. Essentially, there are always areas on a chart that represent the relative absence of risk and others that represent the absence of reward, and if the news pushes stock prices to one of those levels, it is often possible to predict the end result.

In technical analysis of the stock market, levels of support tend to correlate with a perception of an absence of risk, while levels of resistance tend to correlate with an absence of reward. These levels are not always permanent, and can change rapidly depending on the exact type of analysis. In some instances, a previous resistance level can suddenly become a new support level, and vice versa.

Even though levels can change, as long as a level of support exists there will tend to be a perception of low risk near that level, and when resistance exists traders will see tend to perceive low reward. Thus, it is possible to make a prediction about how traders will react if the stock price reaches either of those levels, even though it is not possible to predict whether either of those levels will actually be reached.

The natural tendency is for traders to sell when prices reach resistance, because resistance represents an area in which the perception of reward typically tends to be low. Just because it’s a tendency doesn’t mean it’s always prudent. That’s because prices sometimes break out above a level of resistance, and the same level that once represented resistance can quickly become a new level of support. What that often entails for traders is that a previous level with a perception of low reward can quickly become a level of perceived high reward. Instead of being a good place to sell, a level of resistance can become a good place to buy – if it gets broken.

OMS 01-10-15

But, in the event that resistance does not break, a lot of traders are likely to come to the same conclusion, and they are likely to reach that conclusion at about the same time. Lots of folks will want to sell their stocks when the reach resistance. This can occur even when the news is good, and very often does, because it generally takes some sort of good news to propel stocks towards their resistance levels.

When stocks hit resistance, it can be like hitting a brick wall. While resistance levels can occur for a number of reasons, one of the more reliable occurrences tends to be when certain Long Call options trades on the S&P 500 fail to earn a profit.

Long Call options trades only return a profit during a strong rally, particularly at-the-money Long Call trades. So, when these trades fail to return a profit at expiration, it is a sign of weakness. Such weakness makes traders more apt to see any subsequent rally as a gift; thus these traders are more likely to take that gift and run away from their stocks with whatever profits they have.

Long Call option trades are therefore a strong predictor of future resistance. Should the market rally after Long Calls have entered a period of un-profitability, such a rally is likely to meet resistance. For that reason, the un-profitability of Long Call option trades on the S&P 500, especially at-the-money options opened 4-months to expiration, is known here as the “resistance” stage, since it often precedes future strong resistance in the S&P.head&shoulders

Bull Market Stage 3 – the “resistance” stage occurred several weeks ago, and it occurred again this past week. Last time this occurred, in early December, the S&P hit a brick wall when it reached new all-time highs in late December. Now that Bull Market Stage 3 has occurred again in early January, it is quite possible the S&P could soon hit another brick wall.

The difference between a brick wall now and a brick wall several weeks ago, is that this time would represent the third attempt to break out above the 2075 level on the S&P 500. Three attempts without a significant break of a brick wall can be dangerous. It makes traders doubt that the market has enough momentum to break the wall. It makes the perception of a potential reward for stock owners much lower.

The third attempt at a brick wall, should it fail can bring on a major sell-off in stocks. Such an event usually creates a chart pattern of either a triple-top or head-and-shoulders. Either pattern can be very bearish, at least in the short term. These patterns each show the power of the decrease in perception of reward that comes from unbreakable resistance.

It is very important for traders to be aware of:

  • Bull Market Stage 3 has likely created a brick wall of “resistance” in the S&P 500
  • If the S&P fails to break resistance soon, it would create a bearish triple-top or head-and-shoulders chart pattern
  • Resistance lowers traders’ perception of potential rewards of stock ownership
  • Breaking of resistance lowers traders’ perception of the risk of stock ownership
  • If the S&P does indeed break above resistance, the decrease in the perception of risk could fuel an impressive rally

 Stocks and Options at a Glance 01-10-15

* 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 3 – the “resistance” stage.

On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending January 10, 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 +2.7%.
  • Long Call and Married Put trading are each currently not profitable (B-).
    This week’s loss was -0.9%.
  • Long Straddle and Strangle trading is currently not profitable (C-).
    This week’s loss was -3.6%.

The combination A+ B- C- occurs whenever the stock market is at Bull Market Stage 3, the “resistance” stage, which gets its name from the tendency of stock prices to experience strong resistance, often like a brick wall, if recent highs are approached.

Options Market Stages

Click on chart to enlarge

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 01-10-15

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 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 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 that the most recent rally was 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 1918 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 1918 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 01-10-15a

Profits from Long Call trading returned several weeks ago, a major signal of a return to bullish confidence and strength. Bear markets, even during the strongest bounces, have historically never been strong enough to cause Long Calls to profit. The current presence of Long Call profits therefore contradicts the premise that a Bear market is underway, even though recent Covered Call losses suggest the recent rally is just a massive trap – a massive dead-cat bounce in an otherwise Bear market downtrend.

If the S&P manages to close the upcoming week above 2048, Long Calls (and Married Puts) will retain profitability, suggesting the Bulls have retained confidence and strength. Levels above 2048 would suggest a continuation of recent sentiment, notably confidence by the Bulls. Below 2048, 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 01-10-15

The LSSI currently stands at -3.6%, which is normal and not a level of concern, as it is indicative of a market that has neither become overly range-bound nor over-extended.

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, no breakout is likely to occur on its own accord, without a sufficient news catalyst, because the LSSI is normal. 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 normal. 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 2112. Values above S&P 2112 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 2192 this week. Values above 2192 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. 2192 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 1993 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 1993 would likely bring a violent snap-back rally or else a violent resumption of the most recent downtrend. The 1993 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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