By Chris Ebert

In last weekend’s S&P 500 Options Market Analysis it was noted that“… a breakout is now becoming more likely to occur for no reason at all other than the fact that traders have become anxious due to several months of range-bound stock prices…”

dowThat observation, that the trading environment was conducive to a very large move – a breakout – in stock prices, was not based on opinions, hunches or feelings, but on a rather simple analysis of stock options. Historically, major moves in stock prices have tended to occur when certain Long Straddle options are performing remarkably poorly. (Long Straddles are one of three basic strategies that comprise the weekly Options Market Analysis)

The #LSSI, presented here each weekend, is an index that measures Long Straddle option trade performance (and also Long Strangle performance), hence the name Long Straddle/Strangle Index or #LSSI. When the LSSI reaches extremely low levels, as it did a few weeks ago, one can expect major moves in the S&P 500 such as the huge rally that occurred this past week that sent the S&P soaring 100 points higher by Friday and the Dow nearly 1000 points off Tuesday’s lows.

The recent move, one of the biggest rallies for the stock market in years, was not a surprise to anyone who follows the LSSI. The direction of the move may have surprised a lot of traders, but the magnitude of the move was not surprising at all given the recent LSSI numbers.

Some may say “What good is it if I know it is likely that there is a big move coming, but I don’t know if it will be a big move up for stock prices, or a big move down?” After all, it would be very risky to simply buy a bunch of stocks hoping for a big move, since a big move down could result in horrible losses.

Stock options are perfect for such occasions. That’s because stock option trades can be structured in a way that benefits from the move itself without regard to the direction of that move. Even without the use of options, a trader can benefit from knowing that a big move is on the way by:

  • being ready to follow the trend once the move is underway
  • choosing those stocks most likely to benefit from a strong trend
  • being prepared to “buy-the-RIP” in an uptrend or “short-the-DIP” in a downtrend, adding to winners where appropriate, rather than waiting for a retracement that might not occur
  • using stop-loss orders to un-follow the trend if the trend goes the wrong direction

The weekly analysis presented here is not intended to predict what will happen next, but rather to give traders an edge by allowing them to see what has happened in the past. By knowing what is happening in the options market today, a trader can prepare for events in the stock market that have historically followed similar environments in the options market.

The following analysis is therefore intended to give all traders an option-trader’s perspective, even those traders who might have no interest in trading options. This week’s options environment is entirely different than last week’s. This week, the options suggest the likelihood of the S&P 500 hitting a brick wall, finding a level at which stock prices have risen as far as they can rise, and having difficulty rising any further. As always, traders should prepare for what the options analysis says is likely, but it is just as important to prepare for the unlikely. For, if it turns out there is no brick wall where a brick wall should exist, the absence of that brick wall could have major implications, as explained below.

 Stocks and Options at a Glance 12-20-14

* 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 2 – the “Digesting Gains” stage.

On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending December 20, 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 +2.7%.
  • Long Call and Married Put trading are each currently profitable (B+).
    This week’s profit was +0.7%.
  • Long Straddle and Strangle trading is currently not profitable (C-).
    This week’s loss was -2.0%.

The combination A+ B+ C- occurs whenever the stock market is at Bull Market Stage 2, the “Digesting Gains” stage, which gets its name from the tendency of stock prices to experience strong rallies interspersed with noticeable periods of sideways moves, pullbacks, or range-bound consolidation (otherwise known as normal, healthy digestion of gains).

Options Market Stages

Click on chart to enlarge

The chart above shows the main qualities that define each stage, as well as how to identify each stage using simple S&P 500 options.

Stock Market Environment has Changed

Two weeks ago, the S&P 500 entered Bull Market Stage 3 – the “Resistance” stage. It gets its name from the propensity for the S&P to hit a brick wall of resistance, at least temporarily for a few weeks, if prices approach recent highs after rallying off their current lows. Although the current environment is Stage 2, the effects of Stage 3 can linger for several weeks.

Resistance is not necessarily permanent, though it can be, but often occurs as herds of traders exit previously-losing trades when those trades return to break-even (when stock prices rise back to their recent highs after a significant pullback in prices), thus supplying too many shares for the market to absorb without at least a temporary pullback or consolidation in prices. Only with an outside force – an overwhelming demand for shares that overshadows the supply- can the herd be steered through the brick wall and beyond it.

Essentially, the market tends to run out of buyers if stock prices get back to their old highs. Without some kind of push, many traders shy away from buying stocks at their highs, especially all-time highs. Sure, there will always be speculators, and those folks may have no qualms about buying high since they intend to sell even higher. But, by and large, the natural tendency is always for profit-taking at the highs.

Thus, the natural tendency is always for a brick wall of resistance to develop when stock prices hit highs. In a smooth, non-volatile, up-trending market, the tendency to take profits at highs may be strong, but not overwhelmingly so. When the trend is smooth and consistent, the natural tendency to take profits will always weigh on a trader, but the consistency of the uptrend will make a trader think twice.

  • “If I hold on a bit longer, this uptrend just might continue, and I can sell my stocks at even higher prices than they are at right now”

When a trend has become questionable, the fear of missing the highs becomes much more pronounced.

  • “If I don’t sell right now, I might never get another chance to sell my stocks at prices this high.”

Bull Market Stage 3 is likely to induce the latter. That stage can only be reached when the up-trend has become questionable. Stage 3 can only occur when stock prices experience a quick, significant pullback, or else a drawn out choppy range-bound sideways chop fest. Either scenario makes traders question the trend; and when they question the trend they tend to take profits off the table whenever such profits appear.

OMS 12-20-14

Once Stage 3 is reached, the stock market becomes a “sell-the-rip” environment, until further notice. It doesn’t matter if the S&P rallies higher, into Stage 2 where it is today; once Stage 3 has occurred, the market is a “sell-the-rip” environment until acted upon by an outside force.

The Brick Wall

Since the S&P is now in a post-Stage 3 environment, by all accounts there should be one giant brick wall at the recent highs. Those approximate S&P highs correlate with highs in other indexes as well:

  • S&P 500 – 2075
  • Dow – 18,000
  • Nasdaq – 4350

If stocks hit a brick wall at or near those highs, that is to be expected, and a trader should be prepared for such a brick wall. But, just as important as hitting the brick wall is what could happen if the brick wall crumbles.

If stock prices continue to climb, and the brick wall does not offer strong resistance, it would indicate there was an outside force propelling stocks higher. Traders preparing for a brick wall, either by taking profits or by shorting at the highs, would be forced to capitulate in a brand-new Bull rally if the brick wall falls.

The additional buying pressure caused by capitulation would almost certainly drive the S&P into the Lottery Fever Stage. So, while this options analysis is not concerned with predicting that Lottery Fever will soon begin, it certainly suggests that in the absence of a brick wall the next logical stage would be that of Lottery Fever.

As stated above, once Stage 3 is reached, it becomes a “sell-the-rip” market UNTIL FURTHER NOTICE. Stage 1, should it occur, serves as that notice. Lottery Fever erases the “sell-the-rip” mentality, turning traders back to a buy-the-dip mentality as they capitulate to the breaking of the brick wall.

A break above the all-time high for the S&P 500, near the 2075 level, would be an indication of weakness in the brick wall. A break above 2115 this coming week would signal the presence of Lottery Fever, and would serve as notice that the brick wall had been destroyed. A break above 2075 without also breaking 2115 would be suspicious, as it could be a Bull trap. Stage 1 Lottery Fever, should the S&P push above 2115 this week, would go a long way towards eliminating the potential presence of a Bull trap.

Conclusion

Stock prices have historically hit a brick wall of resistance in the past, given the recent environment for stock options. Traders should be prepared for the likelihood of such a brick wall, and alter their trades to limit the risk that could be associated. Typically a brick wall results in sideways consolidation at the highs, or else a pullback off the highs, sometimes lasting several weeks. Traders should also be prepared to act quickly if the brick wall crumbles, because a serious case of Lottery Fever would be expected following the demise of the wall.

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.

 CCNPI 12-20-14

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 October dip into unprofitability, the first such instance in 3 years for Covered Calls, a major signal for the potential of an upcoming Bear market. As bullish as the current market may appear, traders should be open to the possibility that a Bear market is certainly not impossible.

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

If the S&P falls below 1954 over the upcoming week, Covered Call trading (and Naked Put trading) will become un-profitable, indicating that the Bears have regained control of the longer-term trend. Above S&P 1954 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.

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.

 LCMPI 12-20-14

Profits from Long Call trading returned several weeks ago, 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 contradicts the premise that a Bear market is underway, even though recent Covered Call losses suggest the recent rally is just a massive trap – a massive dead-cat bounce in an otherwise Bear market downtrend.

If the S&P manages to close the upcoming week above 2061, Long Calls (and Married Puts) will retain profitability, suggesting the Bulls have retained confidence and strength. Levels above 2061 would suggest a continuation of recent sentiment, notably confidence by the Bulls. Below 2061, weakness and a lack of confidence should be apparent.

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. Profits are therefore compelling evidence that the Bulls are firmly in control.

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.

 LSSI 12-20-14

The LSSI currently stands at -2.0%, which is normal and not a level of concern, as it is indicative of a market that has not become range-bound. Range-bound markets tend to demand a breakout in prices from the range of the past several months. A breakout can always occur for other reasons, for example surprising economic news. But a breakout can also occur for seemingly no reason at all, other than the fact that traders have become anxious due to several months of range-bound stock prices. Currently, no breakout is likely to occur on its own accord, without a sufficient news catalyst, because the LSSI is normal.

Negative values for the LSSI represent losses for Long Straddle option trades. Small losses are quite common when a Bull market is consolidating. Large losses only occur when stock prices have become unsustainably range-bound, usually preceding a major price breakout.

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 become profitable during the upcoming week only if the S&P closes above 2115. Values above S&P 2115 could only occur during an irrationally exuberant Bull market. Values above 2115 would therefore suggest the presence of an overbought market, but sustainably overbought – as occurs during the Lottery Fever Stage.

Excessive Long Straddle trading profits (more than 4%) will not occur unless the S&P either exceeds 2195 this week. Values above 2195 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. 2195 therefore represents the extreme upper limit of the Lottery Fever Stage.

Excessive Long Straddle losses (more than 6%) will not occur unless the S&P moves to very near 1994 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 1994 would likely bring a violent snap-back rally or else a violent resumption of the most recent downtrend. The 1994 level therefore divides an ordinary pullback (above it) from a significant Bull-market correction (below it).

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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