By Chris Ebert

It’s difficult to predict the future; some might say it’s impossible. The stock market, as with any process that involves predicting the future, is, as one might expect, very unpredictable. But unlike natural processes that are difficult to predict, for example predicting where and when a storm might strike, the stock market’s unpredictability is intentional.

Whereas a storm may be unpredictable, the inability to forecast its path with 100% accuracy is a result only of a lack of data; the more data – the more accurate the prediction. That’s because, presumably, nobody is steering the storm. If some force outside nature, perhaps some form of consciousness, were to steer a storm, it would not matter how much environmental data was collected, it would not be possible to predict its path without also being tuned to the consciousness controlling its path.

hurricaneAccordingly, it is not possible to predict stock prices with 100% accuracy without understanding the consciousness controlling those prices. Moreover, it is downright impossible to collect enough data to understand the collective consciousness.

Predicting the Future

There will always be unknown variables that push folks to take trades. Your reasons for taking a trade may be quite different than mine, even if we both happen to buy the same stock at the same moment in time. Furthermore, it is possible for you to earn a profit while I take a loss, on the same stock, purchased at the same moment in time. The end result of each trade depends on how long of a time frame each of our trades encompasses.

One of us may intend to hold the stock for several years and the other for just a few hours. Without knowing each other’s intentions, it is impossible to predict the other’s reactions to movements in the stock price. One might be inclined to exit the stock after just a few ticks in the price; the other may have no intention of selling, ever, no matter what the price, unless the funds are needed for another purpose, e.g. retirement.

No matter what our intentions, the ultimate goal of every participant in the stock market is exactly the same – to benefit from probability. A long-term investor who holds stocks for several years or decades is dependent upon the probability that such action will be profitable in the future, simply because it was profitable in the past. Past performance predicts the probability of future results.

If holding stocks for 20 years has always returned a profit in the past, the probability is high that buying stocks now and holding them for 20 years will also be a profitable endeavor. If entering a Position Trade on a breakout above a Darvas Box has had a high probability of profitability in the past, chances are good it will have good results in the future.

The same can be said for buying the dip in an uptrend, selling the rip in a downtrend; buying the 30 RSI, selling the 70 RSI; buying a break above the 50 SMA, selling a break below the 200 SMA; buying support, selling resistance, buying the 61.8% FIB, selling the 161.8% FIB. Whatever the method, the only reason a trader uses it is because it has worked in the past. Even seemingly unusual methods, if they have an historical track record of success, are bound to influence traders. Traders who base their decisions in astrology, for example, are no different than those who trade using traditional technical analysis or long-haul investors who use no analysis whatsoever. Each is using past performance to predict future results.

Stock Market Unpredictability

There is no single right method for trading in the stock market. That’s because there are countless millions of methods that work well. All those successful trading methods have one thing in common; none of them can predict the future with 100% accuracy, and each of them makes allowances for errors.

There are countless methods for being successful in the stock market, but only one way to fail. A trader who attempts to predict the future, without making allowances for errors in the prediction, is doomed to fail eventually. A trader who depends on past performance being a guarantee of future results may survive for a time – with some uncommonly good luck, perhaps a very long time – but eventually the luck will run errorout.

On the other hand, a trader who makes allowances for errors can generally expect to do no worse than to break even over the long term. It is certainly possible for a trader to experience an awful string of bad luck, in which every trade results in a small loss. Repeated hundreds or thousands of times, death by a thousand paper cuts is not entirely impossible, but it’s an exception. Even with a thousand paper cuts, it often only takes a few really good trades to heal all the wounds.

Survival in the stock market depends on nothing more than taking the best shot at predicting the future, and then ensuring the damage on any one trade is small enough, if the prediction proves to be incorrect, that there will be enough funds available for many more trades to come.

Unpredictability is an Agenda

The future of the stock market is not predictable with 100% accuracy. That’s because the collective consciousness that drives the stock market is one that is dependent on unpredictability. No matter what method one uses to make predictions and enter trades, someone else’s profit depends on the failure of that method. Essentially, the stock market behaves like a storm, with one monstrous exception the stock market‘s agenda is to cause the most damage by being the most unpredictable to the largest amount of participants.

Presumably, a storm such as a typhoon or a tornado does not have a mind of its own. It moves in a way that follows the laws of nature. That a storm causes damage, no matter how seemingly targeted such damage may appear, does not prove that the damage was intentional. Damage in the stock market is a different story; it is definitely intentional. Everyone who participates in the stock market depends on damaging other participants as much as humanly possible, whether by taking profits away from others or by causing outright losses for other traders.

The stock market thrives on unpredictability. So, it is important to note instances of unpredictability, particularly unusual instances. Each instance of unpredictability yields a clue as to who is causing the stock market to veer off its path. Who is currently benefiting the most from the current path?

The following analysis uses options traded on the S&P 500 stock index. It is presented here weekly as a means of identifying who is currently being fooled the most by the stock market. Someone is always being fooled; there is always someone whose prediction isn’t working. Option traders are in a unique position to identify the bigger fool. By identifying the bigger fool, traders may avoid becoming the fool themselves, or at the very least make preparations in case it becomes unavoidable.

Click on chart to enlarge

 

* 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 0 – the “Disappearing Fear” stage.

On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending November 22, 2014, 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 +3.7%.
  • Long Call and Married Put trading are each currently profitable (B+).
    This week’s profit was +3.4%.
  • Long Straddle and Strangle trading is currently not profitable (C-).
    This week’s loss was -0.3%.
Options Market Stages

Click on chart to enlarge

The combination A+ B+ C- occurs whenever the stock market is at Bull Market Stage 0, the “Disappearing Fear” stage, which gets its name from the absence of fear, or at least its apparent absence, in regards to any impending large-scale widespread declines in stock prices.

Traditional indicators of fear such as the S&P 500 Volatility Index, or ‘the VIX’ do not always correlate with the emotion of fear, since such indicators cannot measure fear directly; volatility (particularly implied volatility) does not always equal fear. The presence of Bull Market Stage 0, on the other hand, can only occur when traders across the globe are confidently bullish.

Confidently Bullish

Who benefits the most when a stock market is confidently bullish? The obvious answer is – anyone who is confidently bullish. When traders and investors are confident, they tend to ignore negative economic news while focusing on positive developments. Predictably, anyone who owns stocks tends to benefit when the overall consensus is one of confidence.

Confident participants tend to buy stocks, which causes stock prices to rise, which makes participants even more confident than they were before. Their confidence, however, does not make them correct in their assessment of the market. Might does not make right in the stock market. It is entirely possible for the majority to play the bigger fool.

The S&P 500 recently made some moves that have typically preceded Bear markets. This past October, Covered Call trading became unprofitable for the first time in several years. Typically, Covered Call trading has only resulted in losses during a Bear market. If the current market is a Bear market, it certainly isn’t acting like one, though.

Who Benefits the Most?

Stock prices are broadly reaching all-time highs. Major indices such as the Dow and S&P have recently set records. If this is a Bear market, as would be suggested by the recent poor performance of Covered Call trading, it is fooling a lot of traders. In fact, Long Call trading has now become profitable once again, which historically has only occurred during strong Bull markets. If it were to be revealed in the future that the current rally was nothing more than one massive dead-cat bounce in a Bear market downtrend, such a scenario would be likely to have fooled even the options traders, and they’re a tough group to fool.

It may be helpful to ask, perhaps hypothetically “Who would benefit the most from such a huge rally in stock prices as the recent one, if the S&P has indeed entered a new overall Bear-market downtrend?” The answer is – anyone who wants to unload their long stock positions. What better time to unload than when confidence bullishness is rampant?

Bull or Bear

It can’t be both ways. Either this is the first time in more than 10 years that the S&P 500 has avoided a Bear market after entering the red zone (depicted on the chart below), and the avoidance is a testament to the bullish strength and resiliency of the current stock market; or else this recent rally is one of the biggest illusions in recent memory, and more Bulls are being fooled into buying stocks now, before the rug gets yanked out from under them, than at any time in the past 10 years.

OMS 11-22-14

The options tell two stories this week. On the one hand, this appears to be the start of Bull Market Stage 0 – the “disappearing fear” stage, which often leads into Stage 1 and skyrocketing stock prices reminiscent of a Lottery Fever environment. The options also warn that this could be nothing more than a dead cat bounce – a massive dead cat bounce – but truly a temporary rally in a broader decline in stock prices.

The $1-A-Day Solution

Really, it does not matter which prediction is correct, Bull or Bear, so long as preparations are made for that prediction to prove to be incorrect. Fortunately, now is one of the best times to prepare for either scenario. Option premiums are at some of their lowest levels in years. That makes it possible for traders to buy options as protection in case they, themselves, become the bigger fool.

Put options can be used as cheap insurance for stocks, without the need to sell the stocks. Buying Put options allows a trader to prepare for a Bear market while participating in the current Bull market.

At the current level of the VIX, which is hovering around 15 or so, options on a broad Exchange-Traded Fund (ETF) such as $SPY can serve as a cheap form of insurance against a broad-based downturn. Using Put options that are 10% out-of-the-money, for example a Put option with a strike price of $180 is 10% out-of-the-money when $SPY is trading at $200, will provide insurance against anything more than a 10% decline in stock prices.

A diversified portfolio of stocks, one that mimics the S&P 500 benchmark, is easily protected against anything in excess of a 10% downturn in stock prices by buying Put options 10% out-of-the-money on a broad ETF such as $SPY. At the current level of the VIX (approximately 15%), protecting a $10,000 diversified stock portfolio using $SPY options with strike prices 10% out-of-the-money and expirations 1-year away, costs about $1 a day.

dollaradayThat means, for $1 a day (per $10,000 in diversified stocks owned), it is possible to enjoy all the benefits of the current Bull market without ever losing sleep worrying about a potential crash.

For example, someone with a $100,000 diversified 401k, IRA or RRSP portfolio could purchase Put options on $SPY though any broker that allows option trading, not necessarily the same broker that administers the stock portfolio. To find the number of options on $SPY necessary to provide such protection, simply divide portfolio size (e.g. $100,000) by the current share price of $SPY (e.g. $200) then divide the result by 100.

In the above example, $100,000 (portfolio size) divided by $200 ($SPY share price) divided by 100 (shares per standard Put option) = 5 standard Put options.

Theoretically, using the example, a trader with a $100,000 stock portfolio could protect that portfolio from anything in excess of a 10% decline by buying 5 Put options, using the $180 strike price (if $SPY was trading at $200) and an expiration date of December 2015 (approximately 1-year from today). The total cost, on average,  should be approximately $1 a day per $10,000. For a $100,000 portfolio, the cost would be an average of approximately $10 per day or $3650 total for a year’s worth of protection.

The $1-a-day estimate only applies when the VIX is very low, at levels of approximately 15% or less. When the VIX is high, it it because option premiums are high; option premiums are used in order to calculate the VIX. When the VIX is low, as it is currently, protecting a stock portfolio is relatively inexpensive because options are fairly cheap. $1 a day tends to be very affordable. Rallies in the S&P 500 often offer the lowest VIX – the lowest option premiums – thus the best opportunity to protect a stock portfolio. Waiting for a downturn to buy Put options is like waiting for the house to catch on fire before buying fire insurance. Put options get very pricey, very quickly, when stock prices tumble.

That’s why now is a great time to consider whether buying Puts makes sense, while fear has essentially disappeared. Bull Market Stage 0 always offers great Put pricing.

In the event of a downturn, the Put options will gain value, essentially making up for all but the first 10% of the stock portfolio’s losses. If the Put options are opened in a standard, taxable account, it means the gains on the Put options might be taxable, while losses incurred in the stock portfolio might not be deductible, if those stocks are held in a tax-advantaged account. Even so, paying taxes can be better than suffering through a market crash unprotected.

In the event the current Bull market keeps roaring, the portfolio will experience all the gains as stock prices soar. In the case of an uptrend, the premium paid for the Put options will be lost, but not wasted, since the peace of mind they provide can be priceless.

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.

 Covered Call Trading

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 dip into unprofitability, the first such instance in 3 years for Covered Calls, a major signal for the potential of an upcoming Bear market.

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 current rally is a trap. Even if it turns out not to be a trap, it is better to be safe than sorry.

Covered Call unprofitability suggests that the Bears have now taken control and will likely remain in control for many weeks or months in spite of temporary rallies, no matter how bullish those rallies may appear. Historically, once the Bears have taken control, they do not relinquish that control until they have overstepped their authority over the stock market, as indicated by the Long Call/Married Put Index (#LCMPI) and Long Straddle/Strangle Index (#LSSI), shown below.

If the S&P falls below 1865 over the upcoming week, Covered Call trading (and Naked Put trading) will become un-profitable, indicating that the Bears retain control of the longer-term trend. Above S&P 1865 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.

Profitability of Covered Calls and Naked Puts during a Bear market is not by itself evidence of a flaw in the analysis that determined a Bear market was underway,  since a temporary return to profitability often occurs during a ‘dead-cat’ bounce. Long Call profits, however, generally do not occur during a dead-cat bounce. Thus, the current level of the Long Call/Married Put Index (#LCMPI), shown below, contradicts the assumption of the #CCNPI that a Bear market is underway. Essentially Long Call trading says this is clearly a Bull market; Covered Call trading says it’s clearly just a bounce in a broader Bear market. They can’t both be correct. The options are therefore uncommonly inconclusive this week.

The #LCMPI clearly signaled the presence of a strong, confident Bull market this past week. Long Calls are currently profitable, which only happens in a strong Bull market.

The #CCNPI clearly signaled the beginning of a fresh new Bear market several weeks ago. Covered Calls suffered losses, which only happens once a Bear market is underway.

If no Bear market ensues within the next month or so (by February 2015) it would mark the first time in at least 10 years that the #CCNPI has sent out a false signal.

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.

 Long Call Trading

Profits from Long Call trading returned this past week, 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 places serious doubt that a Bear market ever was ever underway, despite indications from Covered Call/Naked Put Index (#CCNPI) to the contrary. The contradiction is the first of its kind in at least 10 years.

As long as the S&P closes the upcoming week above 1999, Long Calls (and Married Puts) will remain profitable, suggesting the Bulls have regained confidence and strength. Levels above 1999 would suggest a significant shift in sentiment, notably a huge return of confidence by the Bulls.

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.

Profitability of Long Calls and Married Puts during a Bear market is therefore evidence of a serious flaw in the analysis which determined that a Bear market was underway, since it ostensively is not underway if these trades are profitable. Covered Calls and Naked Puts sometimes profit temporarily during Bear market bounces, but historically Long Calls and Married Puts have not.

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

 Long Straddle Trading

The LSSI currently stands at -0.3%, which is normal, and indicative of a market that is not in imminent need of a major breakout from the trading range of the last few months. Negative values for the LSSI represent losses for Long Straddle option trades. Small losses are quite normal and usual for Long Straddle trading. Large losses are not.

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 not be profitable during the upcoming week unless the S&P closes above 2066 or below 1798. Values above S&P 2066 could only occur during a Bull market. Values above 2066, should those values be reached, would suggest an overbought market, but sustainably overbought.

Historically, during uptrends, the profitability of Long Straddle trading has coincided with runaway rallies, as the increase in stock prices becomes so swift that it takes on a life of its own. Long Straddle profits indicate surprise, and such surprise has an effect on traders sitting in cash on the sidelines, as well as those sitting on short stock positions, enticing each to buy stocks they otherwise would not be inclined to purchase.

Excessive Long Straddle trading profits (more than 4%) will not occur unless the S&P either exceeds 2143 or else falls below 1720 this week. Values above 2143 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.

Excessive Long Straddle losses (more than 6%) will not occur unless the S&P moves to very near 1950 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 1950 would likely bring a snap-back rally or else a violent resumption of the most recent downtrend.

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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