By Chris Ebert

9-livesIf a stock-market participant only knows two things about the options market, these are the two most important truths:

  1. Covered Call trading is only unprofitable in a Bear market
  2. Long Call trading is only profitable in a Bull market.

Of course, the strike prices, expiration dates and holding time of the Call options will have an effect, to some degree. Nevertheless, those two basic rules stand the test of time. Call options are a wonderfully simple and effective indicator for individual stocks as well as the stock market as a whole.

If one gets a little more specific with the Call options, the Bull-Bear indicator becomes even more effective and more reliable. Using ATM (at-the-money) strike prices (strike price of an ATM Call option is the same or nearly the same as the share price of the stock) makes the trades more accurate as an indicator. ATM Covered Calls only suffer losses in Bear markets; ATM Long Calls only return profits in Bull markets, especially when the options are held through expiration.

A Bear market or Bull market depends on the time frame of the observer. For example, a Secular Bull market, lasting 5 years or more, may have smaller Primary Bear markets embedded within it, since Primary trends last a year or so. Furthermore, a Primary Bull market may have smaller Secondary Bear markets embedded, since Secondary trends only last a few months at most.

Using ATM Covered Call trading and ATM Long Call trading as indicators works very well for Secondary trends (weeks or months). That is because option premiums are based on the foreseeable future of the stock market. The foreseeable future lies somewhere between the near-randomness of the next tick for stock prices in the immediate future and the as-yet unknown variables of the distant future.

It is generally more difficult to predict where stock prices might go in the next day or so than where they might go in the next few months, since prices tend to follow the current trend in the longer-term, but may be subject to short-term intraday or daily fluctuations that do not affect the overall trend. Unknown economic developments in the distant future make it more difficult to know how long the current trend will last, so stock prices a year or more from today can be as difficult to predict as the next tick.

The next few weeks or months – that’s usually the clearest foreseeable future for the stock market – the Secondary trend. So it stands to reason that options particularly those with an expiration date of several weeks or months in the future would be the best indicators of whether the Secondary trend for the stock market is bullish or bearish. The following analysis chooses 4 months (112 days) as the expiration date for options on the S&P 500 index ($SPY or $SPX).

ATM Covered Call $SPY trades opened 4-months to expiration are only unprofitable, at expiration, in a Bear market. ATM $SPY Long Call trades opened 4-months to expiration are only profitable, at expiration, in a Bull market. Additionally, ATM $SPY Long Straddle trades opened 4-months to expiration help settle discrepancies when Covered Calls and Long Calls do not clearly indicate whether the Bulls or Bears are in control of the Secondary trend. When a “dead-cat bounce” causes Covered Call profits to signal bullishness, but Long Call losses signal a failure to return to bullish strength, extreme Long Straddle losses help clearly define the border that separates a Secondary Bull market from a Bear market.

Stocks and Options at a Glance 10-25-14

Click on chart to enlarge

* 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 – Bear Market Stage 6 – the “Phew!” stage.

On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending October 25, 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 +1.2%.
  • Long Call and Married Put trading are each currently not profitable (B-).
    This week’s loss was -2.3%.
  • Long Straddle and Strangle trading is currently not profitable (C-).
    This week’s loss was -3.5%.

The combination A+ B- C- occurs whenever the stock market is at Bear Market Stage 6, the “Phew!” stage, which gets its name from the collective sigh of relief from stock owners during the first dead-cat bounce higher for stock prices which occurs immediately after the first major sell-off of a new Bear market.

The combination A+ B- C- also occurs at three other stages: Bull Market Stage 3 “resistance” which only occurs during a minor pullback in an otherwise roaring Bull market, Bull market Stage 5 “all clear” which occurs after a healthy Bull market correction, and Bear Market Stage 9 “bargain” which only occurs after a mature Bear market has neared its bottom. None of those other stages is applicable today, with the possible exception of Stage 5, which is improbable yet possible and therefore requires attention.

Bull Market Stage 3 only follows Stage 1 (which is so bullish that Long Straddles are profitable) and Stage 2 (which is moderately bullish, so that Long Calls are profitable). Neither of those types of trades has been profitable for several weeks. This is clearly not Bull Market Stage 3.

Bear Market Stage 9 only follows Stage 7 (which is so bearish that Long Straddles are profitable) and Stage 8 (which is ridiculously bearish, so that Long Straddles are extremely profitable). Neither of those has occurred recently. This is clearly not Bear Market Stage 9.

Bull Market Stage 5 only follows Stage 4 (in which a healthy correction either does not become so severe that Covered Call trading turns unprofitable, or else Covered Call losses are insignificant). Since Covered Call trading has recently suffered two consecutive weeks of significant losses, it is improbable that this is Bull Market Stage 5, yet not entirely impossible.

Options Market Stages

Click on chart to enlarge

Neither Bull nor Bear

Covered Calls opened 4-months ago, at-the-money, on $SPY are currently expiring profitably. That’s bullish. Long Calls are not expiring profitably; and that’s bearish. To settle the discrepancy requires a look at the option performance in context.

Who was in control most recently, the Bulls or the Bears? The answer is simple. The recent sell-off that brought the S&P into the 1800s in a matter of a few weeks from its previous highs above 2000 was brought to us by the Bears. The sell-off was so severe that Covered Calls became unprofitable. Covered Calls are only unprofitable in a Bear market.

The bounce higher in recent days is certainly a bullish sign, but there is no bullish strength. Long Calls have not become profitable. Long Calls are profitable in a Bull market. If Long Calls did become profitable, it would be safe to say that the recent Bear-market alarm was a false one. But, they are not. Unless Long Calls become profitable once again, it has historically been a sign of a dead- cat bounce in stock prices.

Since the current market is one of only two viable scenarios described above (either Bear Market Stage 6 or Bull Market Stage 5)  in which Covered Call profits signal bullishness and Long Call losses signal a lack of bullish strength, it is helpful settle the difference using Long Straddle trade performance. in other words, Long Straddles clearly define the limit of a dead-cat bounce. Anything above that limit suggests the Bears never fully had control, anything below it confirms that they were in control and remain in control despite the bounce.

Long Straddles are typically losing trades. They are expensive to open, thus by design they are meant to return profits only after surprisingly-large moves in stock prices. Losses are normal. That said, extreme losses are not normal. ATM Long straddles opened 4-months to expiration rarely experience losses amounting to 6% of the share price. Such losses, since they are rare, are actually great indicators.

Extreme Long Straddle losses only tend to occur when stock prices are poised for a very large move. When losses approach the 6% threshold (denoted by the orange line on the chart), as they did this past week, a major move in stock prices tends to occur in the following weeks. Stock prices tend to break out of their current range, one way or the other. The reason is rather simple: Long Straddles only experience extreme losses when stock prices have become extremely range-bound. Typically the stock market does not tolerate range-bound conditions for long.

Options Market Stage 2014-10-25

Range-bound markets represent a stalemate between the Bulls and the Bears. Everyone is taking huge risks, Bulls by owning stocks, Bears by shorting them, and yet nobody seems to be getting any reward for all that risk during a stalemate. It usually doesn’t take long for one side to simply take their risk off the table. Either the Bulls will sell some stock and move to the sidelines until a real trend becomes visible, or else the Bears will do so, and buy to cover their shorts, thus moving to the sidelines. No matter which side caves in first, the subsequent move in stock prices tends to be violent.

A level of -6% for Long Straddle trading therefore marks the level at which stock prices are least likely to remain for long. It is one of the most unsustainable levels the stock market ever experiences. Prices are almost certain to break out, in major fashion, either higher or lower than their current level, and they are likely to do it sooner rather than later. In a true Bear market, the S&P 500 will not break out above the orange line.

After a dead-cat bounce, Bear market breakouts are always to lower levels. Therefore, as long as the S&P remains below the orange line, below the level of extreme loss for Long Straddle trading, it is safe to assume this is still a Bear market. No matter how well Covered Call trading performs, no matter how bullish the market might seem, it isn’t truly a Bull market unless the S&P breaks above the orange line.

Bear Market Stage 6 is definitely a confusing stage for the stock market. But Long Straddle trading yields important clues. Covered Call profits are a bullish sign; long Call losses indicate no confidence and strength behind that bullishness; Long Straddle losses indicate the market is poised to break out one way or the other.

Above approximately S&P 1954, in the upcoming week or so, any major breakout above 1954 is something for which traders need to be prepared, as improbable as such a move would be in a true Bear market, because it would mean the Bears were never really in control. Anyone with short stock positions, Naked Calls, Covered Puts, or Long puts, could get burned pretty badly. A major sell-off below 1954 would confirm that Bear market Stage 6 was well underway, and obviously would not be good news for long stock positions, including those holding Covered Calls, Married Puts, Protective Puts or Naked Puts.

Essentially a breakout above 1954 suggests Bull Market Stage 5 is underway, which invalidates the conclusion that a Bear market was ever underway at all; whereas a breakout below 1954 confirms Bear Market Stage 6 is ongoing, and validates the options market analysis. 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.

Covered Call Trading

Covered Call trading did not experience a single loss in 2013, and the streak endured until October 11, 2014, ending a streak of nearly lossless trading extending all the way back to late 2011. That means the Bulls were in control continuously for nearly 3 years.

The Bears have now taken control and will likely remain in control for many weeks or months in spite of temporary rallies, no matter how bullish those rallies may appear. Historically, once the Bears have taken control, they do not relinquish that control until they have overstepped their authority over the stock market, as indicated by the Long Straddle/Strangle Index (#LSSI), shown below.

If the S&P falls below 1915 over the upcoming week, Covered Call trading (and Naked Put trading) will become un-profitable, indicating that the Bears retain control of the longer-term trend. Above S&P 1915 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 only temporary as long as the Bulls lack strength and confidence.

Profitability of Covered Calls and Naked Puts during a Bear market is not by itself evidence of a flaw in the analysis that determined a Bear market was underway. Profitability is only evidence of a flaw if it coincides with either Long Call profits or with excessive Long Straddle losses, as set forth in the descriptions of the Long Call/Married Put Index (#LCMPI) and Long Straddle/Strangle Index (#LSSI), shown below.

A level above 1915 this coming week would actually be quite within normal expectations for the early stages of a Bear market, specifically described as Bear Market Stage 6 in the chart above. The classic “dead cat” bounce creates temporary profits for Covered Calls and Naked Puts (#CCNPI) but not Long Calls or Married Puts (#LCMPI). A textbook “dead cat” bounce will also fail to exceed the level at which Long Straddle losses exceed 6% (#LSSI).

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.

Long Call Trading

Losses on Long Call trading occurred in recent weeks for the first time in several months. Long Call trading became unprofitable this past March, Those losses intensified during April and early May before reverting back to profits for much of the summer. But the winning streak ended in mid-September. 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 prices that stock-sellers are able to obtain from buyers.

As long as the S&P closes the upcoming week below 2020, Long Calls (and Married Puts) will remain un-profitable, suggesting the Bulls lack confidence and strength. Above 2020, Long Calls and Married Puts would become profitable for the first time in several weeks, which would suggest a significant shift in sentiment, notably a huge return of confidence by the Bulls.

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.

Profitability of Long Calls and Married Puts during a Bear market is therefore evidence of a serious flaw in the analysis which determined that a Bear market was underway, since it obviously is not underway if these trades are profitable. Covered Calls and Naked Puts sometimes profit temporarily during Bear market bounces, but never Long Calls and Married Puts.

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.

Long Straddle Trading

The LSSI currently stands at -3.5%, which is near historically extreme low levels, and indicative of a market that is in imminent 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. Small losses are quite normal and usual for Long Straddle trading. Large losses are not.

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 not be profitable during the upcoming week unless the S&P closes above 2072 or below 1863. Values above S&P 2072 could only occur during a Bull market. Values below 1863 are certainly possible in a Bear-market environment, and should those values be reached it would suggest an oversold market poised for a bounce.

Excessive Long Straddle trading profits (more than 4%) will not occur unless the S&P either exceeds 2151 or else falls below 1784 this week. Values above 2151 can only occur in a roaring Bull market. Values below 1784 are certainly possible in a Bear-market environment, but would suggest that stock prices have fallen too far too fast for the rate to be sustainable, thus needing to correct higher, at least temporarily, in order to return to sustainability for the downtrend.

Excessive Long Straddle losses (more than 6%) will not occur unless the S&P moves to very near 1954 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 1954 would likely bring a surprise rally or else a quick slip back into a continuation of the recent downtrend.

Breakouts in true Bear markets are always to the downside. Therefore, a major move above 1954 in the coming week would indicate a serious flaw in the analysis that determined a Bear market was underway. A major move below 1954 this week would serve as confirmation that a Bear market was well underway.

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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