By Chris Ebert

There aren’t too many aspects of the stock market that are dependable. Just ask any trader who has attempted to predict whether the S&P will be higher or lower tomorrow than it is today. It is likely that many will respond that their track record is, at best, only slightly better than flipping a coin – at least among respondents who answer truthfully.

Although predicting whether stock prices will rise or fall often proves difficult for highly experienced traders and nearly impossible for new traders, predicting how high or how low stock prices are likely to go is sometimes an easier task. In stock-market terminology, the analysis of such highs and lows is known as resistance and support, respectively.

A common form of resistance, widely known as brick-wall resistance, has been detailed here quite often, most recently in last weekend’s post entitled “Brick-wall Resistance May Develop Soon”.

Such resistance has been known to affect the S&P 500 when it re-tests a recent high after it has entered Bull Market Stage 3. So, it should have come as no surprise that the S&P hit a brick wall this past week when it re-tested the 1880 level after having entered Stage 3 the previous week.

Although the stock market technically moved back to Bull Market Stage 2 this past week, the specter of brick-wall resistance remains, and may remain for several weeks to come.

Stocks and Options at a Glance

Click on chart to enlarge

*All strategies involve at-the-money options opened 4 months (112 days) prior to this week’s expiration using an ETF that closely tracks the performance of the S&P 500, such as the SPDR S&P 500 ETF Trust (NYSEARCA:SPY)

You Are Here – Bull Market Stage 2

Recognizing whether the stock market is currently at Stage 2 requires a quick analysis of the three categories (A, B, and C) of option strategies shown in the chart above, using a plus (+) for profitable strategies and a minus (-) for unprofitable ones.

  • Covered Call trading is currently profitable (A+). This week’s profit was 3.0%.
  • Long Call trading is currently profitable (B+). This week’s profit was 0.3%.
  • Long Straddle trading is not currently profitable (C-). This week’s loss was -2.7%.

The combination, A+ B+ C-, occurs whenever the stock market environment is currently at Stage 2

Stage 2 is a market environment in which at-the-money Long Calls and Married Puts on the S&P are profitable, at expiration, when opened 4 months prior to expiration. While the profitability of Long Calls and Married Puts only occurs in a market that is strongly bullish, it should be noted that such trades only experienced a tiny 0.3% profit this past week, so the strength of the bulls is currently nothing to write home about.

What Happens Next?

As was mentioned here last week:

Stage 3 is known here as the “resistance” stage because it tends to mark a slowing of momentum for rising stock prices, so much so that recent high prices may tend to become brick-wall resistance in the future. Resistance at recent highs develops as traders become less and less confident that stock prices will ever exceed those highs.

Once Stage 3 is underway, traders who bought stock at recent high prices, now feeling pressure to get out of those stocks if they ever return to break-even, tend to create selling pressure if stocks do return to those same highs. Such pressure does not normally accompany more-bullish stages, such as Stage 1 or 2, since traders at those stages are accustomed to stocks routinely making new highs after each dip. The “buy the dip” mentality becomes much less common when Stage 3 begins.

When analyzing the market as a whole, the recent high of the S&P near 1880 is much more likely to become a brick wall if that level is approached over the upcoming weeks.

Last week’s analysis still applies. Until the market is confronted with some really good economic news, the S&P is likely to meet with resistance if it approaches 1880 again over the next several weeks.

Options Market Stages 03-22-2014

The thing about brick walls is that they tend to outlast the market conditions that created them. In other words, if a brick wall acts as resistance when the S&P hits it from below, it will often act as a strong level of support when the S&P smashes through and then approaches the brick wall again from above.

The strength of the brick wall may be used as an advantage in many types of trades that depend upon the brick wall acting as a level of future support, especially using broad market ETFs such as

SPDR S&P 500 ETF Trust (NYSEARCA:SPY) which tracks the S&P 500

SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) which tracks the Dow Jones Industrial Average.

PowerShares QQQ Trust Series 1 ETF (NASDAQ:QQQ) which tracks the Nasdaq

Although none of the above products offers a guaranteed profit, there are some common option trades worth considering nonetheless. These are just a sample of many possible option trades:

  • Covered Calls – Traders may have an advantage selling Covered Calls with a strike price at or above the level of brick-wall resistance and an expiration date within the next several weeks during which that resistance level is expected to remain valid. The expectation is that the Calls will expire worthless, thereby generating income while resistance remains; eventually the Calls will be assigned when resistance breaks down. Of course, as always, Covered Calls may result in large losses if stock prices decline more than the amount of Call option premium collected.
  • Naked Calls – An inherently risky strategy, but profitable when employed under favorable market conditions, is to sell Naked Calls with a strike price at the level of brick-wall resistance and then cover those Calls with long shares only if the brick wall is broken. The goal is to capitalize on resistance as long as it exists, by collecting premiums on Calls that expire worthless, and then depend upon that same level of resistance providing support in the future to limit risk on the long shares purchased when the resistance was broken. As long as support exists, the Calls will eventually be assigned and the trader will pocket the Call premium.
  • Bear Call Spreads – This strategy, which involves selling Calls with a strike price at the level of the brick wall while simultaneously buying an equal number of Calls at a strike price that is a bit higher, will turn a profit as long as resistance is not broken, with limited losses if resistance falls.
  • Calendar Call Spreads – Here, a trader sells Calls with a near expiration and a strike price at the level of the brick wall and buys the same number of Calls at the same strike price with a further expiration. Such a trader can profit as the near-term Calls expire worthless when the market hits the brick wall and bounces lower, and also profit when the longer-term Calls are held open after resistance crumbles and stock prices soar higher. With such Calendar Call Spreads, there is always a risk that stock prices could decline, resulting in a larger loss on the long Calls than is realized on the short Calls.

The following chart provides a complete description of the Options Market Stages.

Options Market Stages

Click on chart to enlarge

For a more in-depth examination of the Options Market Stages, the following 3-Step analysis is provided.

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.

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 in 2014. As long as the S&P remains above 1750 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. 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.

Long Call Trading

Long Call trading was profitable for almost all of 2013 and thus far in 2014 except for a brief break from August through early October, and a brief break this March. The return to gains this past week marks a shift in sentiment among traders, but the gains are so small, at 0.3%, as to not offer any dependable indication of a change in the emotions of traders. If the S&P fails to close the upcoming week above 1860, Long Calls (and Married Puts) will fail to profit, suggesting the Bulls have lost confidence and strength. 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.

Long Straddle Trading

The LSSI currently stands at -2.7%, which is within normal limits. Profits on Long Straddle trades will not occur this coming week unless the S&P exceeds 1915. Anything higher than 1915 indicates the presence of euphoria, often accompanied by lottery-fever-type bullishness, so the S&P exceeding that level this upcoming week would indicate that Bull market of 2013 was once again underway and the recent pullback was simply a pause in the uptrend.

Excessive profits on Long Straddle trades, such as those exceeding 4%, will not occur this coming week unless the S&P rises above 1987. Despite the presence of euphoria if the S&P was to reach that level, anything higher than 1987 this coming week would be absurd and would likely to result in some selling pressure. Historically, such absurd bullishness has been associated with subsequent pullbacks and, occasionally, Bull-market corrections.

Excessive losses on Long Straddle trades, such as those exceeding 6% will not occur this coming week unless the S&P falls to 1806. At or near that level a subsequent breakout is likely.  That level is important to watch, as anything below it, should it occur, is likely to indicate a major Bull-market correction is underway, and the market would be at risk of breaking out into a lower trading range. As mentioned in Step 1, if such a lower trading range was to fall below 1750, it could be a very, very bearish signal.

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:

Brick-Wall Resistance May Develop Soon

Clocks, Stocks, Options Ready To Spring Ahead

This March It’s S&P 2000 Or Bust – Here’s Why

 

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