By Chris Ebert

Stocks and Options at a Glance

The minor pullback in the Dow, Nasdaq, and S&P last week was not enough to have any significant effect on the current condition of the stock market or the options market. As far as both markets are concerned, we continue to reside at Stage 1 of a Bull market.

Stage 1, also known as the “lottery fever” stage, represents an environment in which stock prices are rising quickly. In fact, the pace of the uptrend at this stage is so fast that it tends to be unsustainable, and historically has led to a correction of at least 5% to 10% in the S&P within 4 months or so. The current Stage 1 began on March 9th.

Although it may be mind boggling, stock prices have risen so fast in recent months, that even if the S&P were to suddenly fall 200 points off its recent high, technically the argument could be made that it was still a Bull market.

By a similar percentage drop, that would represent nearly a 2000 point drop for the Dow. If the S&P and the Dow did experience such drastic sell-offs, Covered Call trading* and Naked Put trading* would remain profitable; and since such trades only experiences losses in a Bear market, profitability would support the argument that it was nothing more than a Bull Market correction.

Stocks and Options at a Glance 05-25-13

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 1

Bull markets tend to progress from stage 0 to stage 5 and then repeat the process, beginning again at stage 0. There is no limit to the number of times the process may be repeated, so a Bull market has the ability to continue indefinitely, until at some point in the future Bull Market Stage 5 fails to materialize, and instead Bear Market Stage 5 takes its place.

Stage 1 represents an over-extended market, which often precedes a correction. This stage has one very distinctive characteristic; all trades labeled with a “+” are profitable.

  • A+ trades (Covered Calls and Naked Puts) are profitable.
  • B+ trades (Long Calls and Married Puts) are profitable.
  • C+ trades (Long Straddles and Long Strangles) are profitable.
Click on chart to enlarge

Click on chart to enlarge

It is impossible to determine with certainty when the current Stage 1 will end. It is, however, possible to recognize what the end of Stage 1 and the beginning of Stage 2 would look like if it were to occur in the near future. The same is true of other market stages shown below:

  • Stage 2 – S&P 1600 to as low as 1560

Stage 2 will arrive when C+ trades stop returning profits. Currently, in the next week or two, Long Straddles and Strangles would stop profiting if the S&P 500 were to fall below a level of about 1600. So, 1600 would likely mark the beginning of Stage 2 – the “digesting gains” stage.

  • Stage 3 – S&P 1560 to as low as 1510

Stage 3 will arrive when B+ trades stop returning profits. In the next two weeks, Long Calls and Married Puts would stop profiting if the S&P 500 fell below 1560. So, 1560 would likely mark the beginning of Stage 3 – the “resistance” stage.

  • Stage 4 – S&P 1510 to as low as 1475

A Bull market “correction”, also known as Stage 4, could potentially bring the S&P down to a level where Covered Calls and Naked Puts break even. Over the next week or two, even if the S&P declined to 1475, Covered Calls and Naked Puts would break even. Since Covered Calls and Naked Puts only suffer losses in a Bear market, 1475 represents the lower limit of a Bull market, at least in the near term.

  • Bear Market Stage 5 – S&P falls below 1475

S&P 1475 is a very important number for late May/early June 2013. A drop of more than a few points below 1475 during that time frame would likely signal the beginning of Stage 5 of a Bear Market.

  • Bull Market Stage 5 – S&P bounces higher from 1475

A bounce higher from the 1475 level, or somewhere nearby, in the next two weeks, would likely represent the end of a correction and the resumption of the uptrend, as Bull Market Stage 5.

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

This week, Covered Call trading and Naked Put trading were both profitable, as they have been for an extended period. That means the Bulls remain 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.

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

This week, Long Call trading and Married Put trading were both profitable. Both forms of trading became profitable in late January. It means the Bulls are not only in control now, but they are confident and strong. 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

On March 9th, Long Straddle trading and Long Strangle trading reached rare and absurd levels of profitability. Such levels normally precede a correction. That does not preclude a possible move higher prior to the correction though. Although rare, the market can, and historically has added gains for as long as 4 months or so, even after the LSSI has indicated that the market is “Due for a Correction”

On May 11th, the LSSI again exceeded the +4% limit that normally precedes a correction. While no technical indicator is correct 100% of the time, over the past 10 years a correction of at least 5% to 10% in the S&P has always ensued within 4 months or so after the LSSI initially topped 4%.

Here in late May 2013, we are now nearly three months past that initial date when the LSSI topped 4%, which would suggest that we have very little chance of getting to July without a correction.

The correction will occur, eventually. An elevated LSSI has always led to a correction in the past, and there’s no reason to suspect this time will be an exception. It’s just a matter of how long until it occurs. 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 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.

Questions, comments and constructive criticism are always welcome. Enter them in the comment box below, or send them to OptionScientist@zentrader.ca.

The preceding is a post by Christopher Ebert, who uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. He studies options daily, trades options almost exclusively, and enjoys sharing his experiences. He recently co-published the book “Show Me Your Options!”

Related Options Posts:

Options Indicate Bull Market Stage 1 Underway

LSSI Index Says Fear Is Near Again

Introducing – Stocks And Options At A Glance

 

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