By Chris Ebert

A recurring theme has been presented here over the past several years: the performance of certain simple option strategies quite often gives an accurate picture of the mood of the stock market. The mood of traders – the emotion – does not determine the future of stock prices, but it surely determines how traders are likely to react to future news.

As with any indicator, be it a Simple Moving Average (SMA), a Relative Strength Index (RSI), an Elliott Wave or a Fibonacci Retracement, the use of options as an indicator is not useful at predicting the future. But, one does not need to know the future in order to be a successful trader. To be successful requires a trader to be cognizant of the emotions present in the market, thus allowing the trader to observe changes in the stock market in their proper context, and react accordingly.

A trader needs to know when other traders are optimistic, because a dip in stock prices makes optimistic traders likely to buy stocks. On the other hand, pessimism makes traders look for the nearest exit. A dip in stock prices in an optimistic market is not the same as a dip in a pessimistic one. The context is important.

Last week saw the first major shift away from optimism in several months. It is still an optimistic market, but not nearly as optimistic as it was just a few short weeks ago. The shift in optimism has been clearly outlined in three recent articles, available here:

Rather that revisit those previous articles, today’s focus is on steps a trader may take to fix a broken trade. What can be done to turn a stock trade into a profitable one after it has experienced an unexpected loss? First, a look at the current stock market, in context.

Click on chart to enlarge

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. (e.g. Profit of $6 per share on an expiring Long Call would represent a 3% profit if $SPY was trading at $200, regardless of whether the call premium itself actually increased 50%, 100% or more)

You are here – Bull Market Stage 3 – the “Resistance” Stage.

Options Market Stages

Click on chart to enlarge

On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending September 26, 2014, this is how the trades performed on the S&P 500 index ($SPY):

  • Covered Call and Naked Put trading are each currently profitable (A+).
    This week’s profit was +2.4%.
  • Long Call and Married Put trading are each currently not profitable (B-).
    This week’s loss was -0.7%.
  • Long Straddle and Strangle trading is currently not profitable (C-).
    This week’s loss was -3.1%.

Using the chart above, it can be seen that the combination, A+ B- C-, occurs whenever the stock market environment is at Bull Market Stage 3, known here as the resistance stage. This stage gets its name from the tendency for stocks to experience strong resistance if they approach recent highs.

Stage 3 often behaves as if traders have become spooked by bullish weakness and therefore have developed a propensity to sell the rip as if each rally is a surprise gift – an opportunity to bail out of remaining long stock positions on a high. It is a stark contrast to the buy the dip mentality of Stage 2 in which each dip was seen as gift for those looking to enter new long stock positions on a low; and an even greater contrast to Stage 1, in which there were few if any dips to speak of.

A chart describing all of the different Options Market Stages is available by clicking the link at the left.

Ways to Fix a Broken Stock Trade

1.Buy more stock
In a roaring Bull market, such as occurs in Bull Market Stage 1, dips in stock prices are few and far between. Thus, some traders may find it enticing to add to losing stock positions, although adding to losers is inherently risky and can quickly lead to ruin. Only in the most bullish of Bull markets does adding to a losing trade make sense, and even when it does make sense it may not be the best choice.

2. Do nothing
In a roaring Bull market, stock prices normally turn around very quickly after a decline. When Bull Market Stage 1 is underway, a dip in stock prices may only last a few days, and thus it may be beneficial to simply wait it out – wait for stock prices to resume climbing higher.

In Bull Market Stage 2, there is a tendency for traders to buy the dip, often sending stock prices higher within a few weeks. Thus, it even more risky than usual to add to losing stocks during Stage 2, but often makes sense to hold onto a losing stock, so long as there is evidence that a strong Bull market remains intact. As always, good risk management demands selling the stock and taking the loss when there is evidence that the Bull run has ended, such as the stock breaking below a major price support level. But, a break of major support is unlikely during Stage 2.

When the S&P 500 is at Stage 1 or 2, the above choices for a stock trader may be sufficient, but for Stage 3 and beyond, there are other choices a trader may wish to consider; and those choices involve options.

OMS 09-27-14c

3. Sell a Covered Call
In a weak Bull market, such as occurs when Bull Market Stage 3 is underway, option premiums are generally a little higher than they were at Stage 1 or 2. The increase can be seen as an increase in implied volatility, and in common indicators such as the VIX which measures implied volatility on the S&P 500 index as a whole. Increased premiums make it possible for a trader who experienced a loss to sometimes recover that loss without selling the stock.

For example, a trader bought 100 shares of stock at $200 and the price has fallen to $197. Rather than take the $3 per share loss, the trader may be able to sell a Call option at the $197 strike price and collect $3 in premium. As long as the stock price remains above $197 through expiration of the option, the trader will have turned a losing stock trade into a break-even trade, since the $3 premium will erase the $3 loss.

Even if the stock price falls, the trader will be better off selling a Covered Call option than simply selling the stock and taking the loss, as long as the stock price does not fall more than an additional $3. There is no guarantee it will not fall an additional $3, so a Covered Call does not guarantee a losing stock trade will be erased, so selling Covered Call options against losing stock positions only makes sense when stocks are in a long-term uptrend, but are experiencing temporary weakness, as often happens during Bull Market Stage 3.

4. Buy a Put
When Bull Market Stage 3 is underway, option premiums are generally low, not as low as they might be in Stage 1 or 2, but lower than they would be in a Correction (Stage 4) or Bear market (Stage 5) for example. A trader who buys a Put option gets a guaranteed sale price for the stock, protecting the stock from further losses. The name Protective Put is often used to describe these options, though the option itself is still just a Put; it is only the name that’s different.

When stocks are in a long-term uptrend, a stock owner can buy a Put to lock in a minimum sale price for the stock. This allows the trader to ride out periods of weakness when stock prices tumble, even when they tumble severely, thus allowing a profit to be taken on the stock if it eventually bounces higher when the weakness has dissipated.

Buying a Put does not guarantee a profit, so doing so only makes sense when there is a good chance of a bounce. Bounces are common when prices begin to fall in a Bull market, especially after the first major sell-off after a prolonged uptrend, which Elliott Wave traders often refer to as Wave A. Wave B entails the bounce. Even if it turns out to be a dead-cat bounce, such a bounce may be an opportunity to unload long stock positions if a trader was able to ride out Wave A using Protective Puts.

5. Open a Collar
When Bull Market Stage 3 is underway, the increase in option premiums, compared to Stage 1 or 2, may dissuade a stock owner from buying Puts. Selling a Call option against the stock, as a Covered Call, will allow a trader to collect enough premium to pay part of the premium to buy a Put option. In some cases, the premium collected on the Call may pay for the entire Put premium, making it a Costless Collar.

For example, 100 shares of stock were purchased at $200 and now the price has fallen to $197. Rather than sell the stock at a $3 per share loss, the trader may sell a Call option at the $200 strike price and then buy a put option at a lower strike price, perhaps at $195.

As long as both premiums are equal, the trader has no out-of-pocket expense for the options. However, the stock is now protected from further losses that might occur below $195. In return for such protection, the trader must give up all gains if the stock climbs over $200. But in the case in which the stock went over $200 the trader would probably be itching to get out of the trade anyway, having gotten back to break even on a previously losing trade.

6. Open a Stock Repair Spreadwrench
During a Bull market, it can be terribly frustrating to sell stocks at a loss on a major dip in prices, only to have stock prices rebound higher soon afterward. One method of avoiding this scenario is to open a Stock Repair Spread.

As with all options, the fancy name of the Stock Repair Spread does not mean it is complicated. Instead, a Stock Repair is quite simple. The intent is to increase the position size of the long stock on the dip and then sell Call options against the position to collect premium. The premium collected will tend to erase losses as long as the stock price does not fall further. That means a trader can quickly turn a losing stock trade to break-even without an increase in the stock price – nifty, huh?

To increase the position size on a dip, one could purchase additional stock, but this is not recommended. It is generally poor risk-management to add to a losing position, especially when the market is experiencing weakness, as it does during Bull Market Stage 3. Instead of buying an additional 100 shares of stock, the trader buys a Call option at an in-the-money (ITM) strike price. Combined with 100 shares of stock the trader already owns, buying the Call option essentially doubles the traders position size, without doubling the risk. Risk is limited on the Call option, since a trader can never lose more than the premium paid.

As an example of a stock repair, let’s say a trader bought 100 shares of stock at $200 and it is now trading at $197. The trader can buy an in-the-money Call option (strike price of the Call is below the current share price) perhaps at the $195 strike price. Essentially, this doubles the trader’s position to 200 shares of stock.

Next, the trader sells the rights to any profit on the stock, by selling two Call options at-the-money (with a strike price equal to the current share price). With the share price at $197, the trader would sell two $197 Call options, since $197 is the at-the-money strike price.

The premium collected from selling two Call options in a Stock Repair Spread is twice as much as the trader would have received from selling a traditional Covered Call option. Therefore, the trader will erase losses much more quickly with a Stock Repair as the stock price remains steady or rises. Stock Repair trades, though, do not protect against a stock price that declines further, so they are not a good choice when stock prices are not likely to find string support, and would therefore be a poor choice in a Bear market (Stage 5) for example.

7. Get out or go short
Fixing a broken stock trade is possible, perhaps even probable, when a Bull market is underway. With the use of options, a trader may even get through a major Bull-market correction unscathed. However, when a Bear market is underway the chances of recovering a losing trade are much lower and the risk of additional loses is much higher. The above repair strategies can be altered to compensate for a Bear market, but it can take more effort than it’s worth. Knowing when to try to repair a broken stock trade is just as important as knowing how to do it. A Bear market is simply not the right time.

Even if a trader manages to succeed in turning a losing trade into a winner in a Bear market, the chances are good that the same trader could have put trading capital to better use by shorting stocks, buying Put options (Long Puts) , selling Call options (Naked Calls), buying Bear Put Debit Spreads or selling Bear Call Credit Spreads.  Or, a trader can simply wait on the sidelines, completely in cash, poised to pounce on the first hint of a return to a Bull market by putting all that freed-up cash into use. A trader too entangled in repairing broken stocks can easily miss opportunities to buy stocks when a downturn suddenly reverses.

Liquidity is Important

For any of the above strategies, except when the stock trade is closed all-together, at a loss, recovering from a losing stock trade always carries the risk of further loss. Additionally, options can exacerbate losses when poor liquidity results in unfair pricing.

Options on which the difference between the bid and ask price is more than 2% present a challenge, and those with a difference of more than 5% or 10% will generally result in too much slippage for a trader to efficiently use them in an attempt to recover losses on a stock. Illiquid options have other uses, but a trader attempting to recover a stock loss is not in a good position to begin with, and thus not in a good position to accept the risk that comes from poor liquidity.  Often it’s better to sell stock at a loss rather than accept the additional risk of illiquid options.

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

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, nearly 3 full years later, in 2014.

As long as the S&P remains above 1884 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. Below S&P 1884 this week, Covered Calls and Naked Puts will not be profitable, and since such trades only produce losses in a Bear market, it would suggest the Bears were in control.

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

Losses on Long Call trading occurred this past week for the first time in several months. Long Call trading became unprofitable this past March, Those losses intensified during April and early May before reverting back to profits in recent weeks and months. But the winning streak ended in mid-September. 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.

As long as the S&P closes the upcoming week above 1988, Long Calls (and Married Puts) will remain profitable, suggesting the Bulls retain confidence and strength. Below 1988, Long Calls and Married Puts will not be profitable, which would suggest a significant shift in sentiment, notably a loss 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 set recent highs as brick-wall resistance, since each test of that high is perceived as a rip to be sold.

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 -3.1%, which is normal, and indicative of a market that is neither in imminent need of correction nor in 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.

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 2040. Values above S&P 2040 would suggest a continuation of the recent euphoric “lottery fever” type of mentality that tends to lead to a rally for stock prices.

Excessive Long Straddle trading profits (more than 4%) will not occur unless the S&P exceeds 2117 this week, which would suggest absurdity, or out-of-control “lottery fever” and widespread acceptance that stock prices have risen too far too fast for the rate to be sustainable, thus needing to correct in order to return to sustainability.

Excessive Long Straddle losses (more than 6%) will not occur unless the S&P falls to 1924 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 break higher from 1924 would be a major bullish “buy the dip” signal, while a break below 1924 would signal a full-fledged Bull-market correction was underway.

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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Related Options Posts:

Minimum Requirement for a Bear Market

Options Witching Effects On Stock Prices

Jobs Or Not, Stocks Are Hot

 

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