By Chris Ebert

The trick, as it were, to successful option trading, is to use the right type of trade at the right time. In fact, timing is crucial, because unlike stocks, every option has an expiration date. When an option expires, it will either return a profit or it won’t. There is no ability to wait for losses to turn into profits, as exists when trading stocks. Expiration day is final.

As it turns out, the past performance of some types of option trades can be used to predict future results of those same trades. Of course there is never a guarantee. Still, the ability to predict whether an option trade will be profitable can be very useful, even if the prediction is not accurate 100% of the time.

That ability – to predict the future based on past results – while of obvious importance for an option trader, can also be very helpful for stock market traders, as shown in the following weekly analysis. To start, it is necessary to know which, if any, of these three common types of option trades are currently profitable: Covered Call trading, Long Call trading, Long Straddle trading.

Stocks and Options at a Glance 05-24-2014

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)

  • Covered Call trading involves the purchase of 100 shares of stock and the simultaneous sale of 1 standard Call option. This strategy is generally intended to return profits when the stock price goes up or sideways, but not down significantly.
  • Long Call trading simply involves the purchase of a Call option. Generally, this strategy only returns profits when the stock price rises, but losses result when the stock price moves sideways or down.
  • Long Straddle trading involves the purchase of both a Call option and a Put option. This strategy tends to return profits only when the stock price makes a large move, either up or down, but returns losses when the stock moves sideways.

You are here – Bull Market Stage 2.

On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending May 24, 2014, this is how the trades performed:

  • Covered Call trading is currently profitable (A+). This week’s profit was +4.1%.
  • Long Call trading is currently profitable (B+). This week’s profit was +2.5%.
  • Long Straddle trading is not currently profitable (C-). This week’s loss was -1.5%.

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 2. For a description of Stage 2, as well as a comparison to all of the other stages, see the chart below (click to enlarge):

Options Market Stages

Click on chart to enlarge

Covered Call Trading

Past profits from Covered Call trading tend to predict future profits. Thus, a good time to sell Covered Calls is often when Covered Calls have recently proven to be profitable.

There is a reason why past profits are a good predictor of future profits. Covered Calls are profitable in just about any market environment, with one major exception: a Bear market. Bear markets tend to develop quickly, but usually not so quickly that it is impossible to observe changes in Covered Call trading.

Covered Calls often become unprofitable during the early weeks of a Bear market. Thus, the most severe part of a Bear Market can usually be avoided by discontinuing the sale of Covered Calls when those trades have proven to be unprofitable for a week or several weeks. There will be lots of time to sell them again later, but only after they are proven to be profitable.

For a visual depiction of the historical predictability of Covered Call profits, based on recent Covered Call performance, see the chart entitled “#CCNPI” Covered Call/Naked Put Index later in this analysis.

Long Call Trading

Just as with Covered Calls, the profitability of Long Calls tends to get clumped together, with profits often lasting for several weeks or months, followed by a period of losses. Thus, the best time to trade Long Calls is usually when Long Calls are already profitable. See the chart entitled “#LCMPI” Long Call/Married Put Index later in this analysis.

Long Straddle Trading

Profitability from Long Straddle trades is a little different than that of the Covered Calls or Long Calls shown above. That’s because of the nature of the Long Straddle trade – it requires a large, often unexpectedly large, move in stock price in order to produce a profit. While it is not possible to predict the unexpected, at least not with any degree of accuracy, there are nevertheless times when unexpectedly large price moves tend to be more common.

First, unexpectedly large price moves often follow an unexpectedly large price move in the opposite direction. A rally that drives prices too high too fast, or a sell-off that results in an oversold condition, can each be followed by some corrective price action. Whether the market needs to correct lower or correct higher,, such a correction can sometimes be a profit opportunity for a Long Straddle trader. Thus, recent Long Straddle profits, especially large profits (i.e. 4% or more in 4 months), sometimes result in future profits when a correction ensues.

Second, unexpectedly large price moves often follow an unexpectedly small price move. When the market becomes stagnant, and prices don’t make any real long-term progress in either direction for an extended period of weeks or months, a price breakout becomes more likely. Since stagnation usually results in Long Straddle losses, recent Long Straddle losses (especially those exceeding 6% in 4 months) tend to result in future profits due to the increased likelihood of a major price breakout that puts an end to the stagnation. For a historical perspective of Long Straddle profitability, see the chart entitled “#LSSI” Long Straddle/Strangle Index later in this analysis.

Stock Trading

The stock trader can take the same information garnered from the three option trades listed above, and use to predict important milestones. Should those milestones be reached in the future, the stock trader may be prepared to act accordingly. Milestones occur whenever there is a change in the profitability of the three option strategies shown earlier.

 Options Market Stages 05-24-2014

As can be seen on the chart above:

  • The S&P is currently above 1737, the red line on the chart, which is a milestone below which Covered Call trading is unprofitable, indicative of a Bear market.
  • The S&P is currently above 1810, the orange line on the chart, which is a milestone at which Long Straddle trading experiences an excessive (6% per 4 months) loss, suggesting a major breakout is imminent. A break below this point suggests a Bull-market correction is underway.
  • The S&P is currently above 1857, the yellow line on the chart, which is a milestone above which Long Call trading is profitable, indicating bullish strength. Below it, Long Call losses suggest bullish weakness, a paradox often resulting in stalemate between Bulls and Bears as evidenced by strong resistance that limits most rallies.
  • The S&P is currently below 1918, the blue line on the chart, which is a milestone above which Long Straddle trading is profitable., indicating surprising, often euphoric, yet sustainable, bullish strength.
  • The S&P is currently below 1990, the green line on the chart, which is a milestone above which Long Straddle trading is excessively profitable (4% per 4 months), indicating unsustainable bullish strength.

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 1737 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 became unprofitable this past March, Those losses intensified during April and early May before reverting back to profits in recent weeks. 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.

Failure of the S&P to close next week above 1857 would be a sign of renewed weakness; and weakness always has the potential of putting downward pressure on stock prices. If the S&P fails to close the upcoming week above 1857, 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.

 Lons Straddle Trading

The LSSI currently stands at -1.5%, 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. Losses only represent an unusual condition for Long Straddle trading when they are excessive, one of three unusual conditions that warrant attention.

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)

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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