By Chris Ebert

With 2014 coming to a close, now is a good time for traders to review their strategies, throw out the bad, and make an effort to embrace the good. The following list of articles encompasses the entire second half of 2014. The record of accuracy speaks for itself.

If these articles have proved helpful in 2014, following Chris Ebert on  Twitter allows access to updates and alerts when new articles are available in 2015.

There is a natural tendency for traders to recall great predictions and forget those that proved to be inaccurate. Such a bias is dangerous, for it can lead towards following the advice of those whose analysis was proven correct merely by luck that their opinion would be right – “I told you XYZ was going to explode!” or simply by being a stopped clock – “I’ve been telling you for a long time that the stock market was reaching a top, and now you see why.”

Every effort is made to present articles here each week that not only give traders an edge, but also give traders a sense of consistency. The goal here is to predict that which is predictable, avoid that which is not predictable, consistently, week after week, and to share everything openly, not to highlight each victory while sweeping the failures under the carpet.

December

winterDec. 22 Most Important Brick Wall of 2014
Important factors for setting a Bull trap, which could exist above S&P 2075 but not above S&P 2115 through early January.

Dec. 14 Stock Traders Herded Like Cattle
Simple methods for spotting outside-manipulation of stock prices, evident below S&P 1880 or above S&P 2075 in December.

Dec. 7 It’s an Option Buyer’s Market
Options, like all insurance policies, are meant to protect owners not enrich them, and a break above S&P 2089 in December would enrich them, indicating irrational exuberance.

November

Nov 23. Insure Stock Portfolio for $1 per Day
With S&P making new all-time highs near 2060 and VIX near record lows, now is a great time to buy Put options for protection.

Nov. 16 All-Time Highs Possible in Bear Markets
A look at ‘Jumping the Shark’ events in the stock market.

Nov. 9 Trick Quickly Reveals Stock Price Manipulation
The S&P 500 likely can’t break above 2034 in November without outside manipulation.

Nov. 2 Options Give Perma-Bears Shadow of Doubt
If the S&P breaks above 2031, the Bulls will have a party.

October

Oct. 26 Options Define Limit of ‘Dead Cat’ Bounce
When is a bounce a temporary return to bullishness, and when is it more permanent?

Oct. 19 Hitchhiker’s Guide to Bear MarketsFibonacci tree
How to recognize, and profit from, a Bear market.

Oct. 12 Stock Market Bull Run Isn’t Done Until…
Some of the most impressive stock market rallies have occurred in similar environments to this one, even though the S&P has fallen to 1900.

Oct. 5 Options + Fibonacci = Powerful Indicator
S&P at or near 1916 would either signal the beginning of a major growth spurt or it would signal the presence of serious disease for the Bull market.

September

Sep 21 Minimum Requirement for a Bear Market
At S&P 2000 now, it could fall 100 points and this would still be a Bull market.

Sep. 14 Options Witching Effects On Stock Prices
Stock market can be affected the third week of March, June, September and December by expiration of options and other derivatives.

Sep 7 Jobs Or Not, Stocks Are Hot
When options indicate Stage 1 Lottery Fever, not even poor jobs numbers can derail a Bull market.

August

Aug 30 Options Reveal 7 Ways Stocks Can End 2014
$VIX could soon hit 25. S&P will not top 2200 this year, and won’t fall below 1850 either unless a new Bear market has begun.

Aug 23 Stock Owners More Important Than Stock Prices
If the S&P rises above 1980 it’s because stocks are under new ownership.

Aug 16 What Every Trader Should Know About Entropy
The S&P is being pulled towards either 1935 or 1988 next week, since each level represents maximum disorder.

summerAug 12 Options Market Stages 10 Year History
The history of the Options Market Stages.

Aug 9 Stock Market – Don’t Fool Me Twice!
Even though S&P has now fallen to 1930, new all-time highs could occur very soon.

Aug 2 Buy The Dip Is Now Sell The Rip
If the S&P were to fall below the 1930s in August, it would probably mean a top had been put in.

July

Jul 27 Stock Options Explain Doji Candles
Points of indecision, and doji candles, are more likely when the Options Market Stages are straddling the line between two differing zones of trader sentiment.

July 20 Don’t Panic Until Call Options Fail
Although S&P has pulled way back to 1950 from its recent all-time high near 1980, there is not yet any compelling reason to panic.

July 13 Stocks Digesting Gains And Nothing More
With the S&P up 10% off its April lows, the current pullback off highs is natural and healthy.

July 6 Proof S&P Won’t Top 2050 Through August
Controversial, but compelling evidence that the S&P 500 has a speed limit that cannot be exceeded, regardless of how bullish the stock market may become.

December 27, 2014 Options Market Stages analysis

Here is how the stock market appears right now, from an option trader’s perspective.

Stocks and Options at a Glance 12-27-14

* 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 27, 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 +1.3%.
  • Long Straddle and Strangle trading is currently not profitable (C-).
    This week’s loss was -1.3%.

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.

Bull Trap Remains a Possibility

As can be seen on the following chart, the S&P 500 has favored the blue line quite a bit during 2014. It is likely it will be attracted to the blue line again in the coming weeks. Thus, one of the most important changes a trader can watch out for in the coming weeks would be the blue line failing to attract.

Whenever the S&P breaks away from the blue line, after a period when it had been attracted, it’s a heads up for traders. It means the environment has changed. So, if the S&P suddenly breaks above the blue line (currently in the 2100-2110 neighborhood) it would mark a shift to irrational exuberance.

Despite the fact that levels above 2110 are irrational, perhaps overbought by some standards, it can be a losing battle to fight such irrationality. It’s often better for a trader to capitulate, join the party while quietly making preparations for the eventual end of the party (such as buying Put options).

OMS 12-27-14

If the S&P breaks significantly to the downside, away from the blue line, it could signal that the recent rally in stock prices was indeed a Bull trap, especially since a Bull trap should always be suspected for several weeks after a period in which the S&P sinks into Stage 3 as it did in early December.

Stage 3 makes traders quick to abandon ship. After all, the S&P was in the 1900s just a week before Christmas. Sure, it’s pushing 2100 now; but those memories of the 1900s are still fresh in traders’ minds. A sell-off now would prey on those fresh memories, so it makes sense to be prepared for serious trouble if the S&P starts to stray significantly below the blue line.

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 12-27-14

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 1927 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 1927 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 12-27-14

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 2044, Long Calls (and Married Puts) will retain profitability, suggesting the Bulls have retained confidence and strength. Levels above 2044 would suggest a continuation of recent sentiment, notably confidence by the Bulls. Below 2044, 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 Either 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 12-27-14

The LSSI currently stands at -1.3%, which is normal and not a level of concern, as it is indicative of a market that has neither become range-bound nor over-extended.

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. An LSSI below -6.0% is considered extreme.

Over-extended markets tend to demand a correction, at least temporarily. A correction can occur for other reasons, such as a news catalyst, but can occur without any catalyst at all when the LSSI is abnormally high. Currently, no correction is likely to occur of its own accord, without a significant news catalyst, because the LSSI is normal. An LSSI above +4.0% is considered extreme.

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 2102. Values above S&P 2102 could only occur during an irrationally exuberant Bull market. Values above 2102 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 2181 this week. Values above 2181 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. 2181 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 1983 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 1983 would likely bring a violent snap-back rally or else a violent resumption of the most recent downtrend. The 1983 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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Related Options Posts:

Most Important Brick Wall of 2014

Stock Traders Herded Like Cattle

It’s an Option Buyer’s Market

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