By Chris Ebert

sunriseVery few things can be known for sure about the future; and even when something is known for sure, the word sure is open to interpretation. Certainly, one can be reasonably sure that the sun will rise tomorrow, though technically even that it is not 100% certain.

It is possible to be sure about the future of the stock market – perhaps not quite as sure as tomorrow’s sunrise – but sure nonetheless. As the Lobour Day holiday is upon us, and with the final trading months of the year now approaching, we may find it helpful to take some time to consider what we actually know for sure about the stock market, inasmuch as we can be sure of anything.

To determine what we know for sure regarding the final months of 2014 for the stock market, we must make a prediction. In order for that prediction – or any prediction – to have value, the accuracy of the prediction must be properly disclosed.

For example, based on centuries of historical data one can predict with nearly 100% accuracy that the sun will rise tomorrow. However, to simply state “The sun will rise tomorrow”, without citing a historiucal basis for the claim, and without interpreting those historical results to disclose the expected accuracy of the prediction, the statement is worthless. Anyone who has ever had to reassure a toddler that the sun will rise again knows the importance of providing a basis for the claim.

Baseless predictions about the future of the stock market are no better than baseless predictions regarding the sunrise. On the other hand, any prediction that has an edge, even if it is a small edge (for example, a 51% likelihood of being correct) can be valuable to a trader so long as the trader is aware of the expected accuracy.

The following analysis reveals how certain aspects of the future of the stock market can be predicted with a high degree of accuracy by studying a few simple stock options. Before predicting the future, it is important to know where the market is right now, and where it’s been.

Stocks and Options at a Glance 2014-08-30

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. (e.g. Profit of $6 per share on an expiring Long Call would represent a 3% profit if $SPY was trading at $200, regardless of whether the call premium itself actually increased 50%, 100% or more)

You are here – Bull Market Stage 1 – the “Lottery Fever” Stage.

Options Market Stages

Click on chart to enlarge

On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending August 30, 2014, this is how the trades performed:

  • Covered Call and Naked Put trading are each currently profitable (A+).
    This week’s profit was +2.8%.
  • Long Call and Married Put trading are each currently profitable (B+).
    This week’s profit was +3.8%.
  • Long Straddle and Strangle trading is currently profitable (C+).
    This week’s profit was +1.0%.

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 1, known here as the lottery fever stage. This stage gets its name from the tendency for stocks to experience explosive periods of gains interspersed with few if any pullbacks, as if traders are buying stocks like they are lottery tickets and the jackpots are huge.

It is important to note that lottery fever often cannot be confirmed until it has been in place for at least a week. The S&P indeed closed inside the lottery fever stage this past week, confirming it for a second week in a row. This is the first confirmation of a new case of lottery fever in 2014; the last case began in November 2013 and ended this past January.

A chart describing all of the different Options Market Stages is available by clicking the link at the left.

Where Has the S&P 500 Been?

The chart below shows where the S&P 500 (white line) has been so far in 2014. (A longer-term 10-year historical chart is available). Immediately, it should be obvious to any trader that the stock market has been in a Bull market continuously for the entire year 2014 to date. There were minor pullbacks, and at one point this past April the pullback bordered on being more of a Correction, but at no time was there a Bear market, at least not as defined later in this analysis.

In fact, there has not been a Bear market for several years. The last Bear market for the S&P 500 ended in November 2011 and it has been a Bull market ever since. That’s an important point for traders to keep in mind, since the accuracy of a stock market prediction can be affected by the environment. Quite simply, for example, many predictions that work in Bull markets do not work in Bear markets.

When predicting the future of the S&P 500, it is therefore very important to be aware of the current environment (e.g. bullish or bearish) as well as the historical environment. Only then can a trader evaluate predictions of the future to determine whether those predictions may be affected if the environment changes.

Options Market Stages 2014-08-30

Valuable Predictions and Worthless Predictions

A prediction without a statement of it’s statistical accuracy isn’t really a prediction at all; it’s an opinion. Opinions can be correct at times, sometimes many times in a row. One may correctly predict whether a fairly-tossed coin will land with its head facing up. But the fact that the prediction was correct does not add to its value; such a prediction is nothing more than a statistically meaningless opinion. An opinion is worthless in the stock market, whether it’s right or wrong.

In fact, opinions can be downright dangerous when they are proven correct, because they tend to lead to a false sense of confidence; and that false sense of confidence can lead to poor trades and, in many cases, devastating losses.

In order for a stock market prediction to provide any valuable information for a trader or investor, that prediction prediction must either:

  1. Have a degree of accuracy in all environments and include a statement of its accuracy (e.g. There’s a good chance this stock will move higher because about 3 out of 4 times in the past 10 years this stock bounced higher when it hit the 200 day moving average)
  2. Have a degree of accuracy in limited environments and include a statement of both its accuracy and its limitations. (e.g. It’s time to buy the dip on this stock because every dip in the past 3 years has been bought when it has been above its 200-day moving average)

If those rules are violated, the prediction is virtually worthless because a trader cannot verify the information. Unverifiable information is not necessarily wrong, but the fact that it is unverifiable makes it essentially useless – no better than an opinion. Every valuable prediction must include a statement of accuracy and a disclosure of the limitations if there are any.

Seems simple enough, yet predictions that do not follow these rules are rampant; and mainstream sources of financial data are not immune. While many sources do provide the necessary data, some television networks, newspapers and other media that offer unverifiable predictions are, at best, not offering a valuable service to traders, and at worst may be intentionally attempting to deceive them. No matter how seemingly trustworthy the source, any prediction which has an unverifiable expectation of accuracy, or that fails to disclose potential limitations of accuracy that might accompany a change in the market environment, is basically useless.

7 Valuable Predictions for 2014

Thankfully the options market offers some help. After all, every stock option in existence comes with a statement of accuracy. The time premium of an option is essentially its worldwide agreed-upon future accuracy. Thus, it can be helpful to all traders, not just option traders, to study the predictions that stock options provide, as in the following analysis.

Several weeks ago, it was shown here how it was possible to predict with a high degree of confidence, essentially a “proof”, that the S&P 500 could not exceed 2050 until at least the end of August 2014. Proof S&P Won’t Top 2050 Through August While the fact that the S&P indeed did not reach 2050 by the end of August does not completely validate the initial analysis (the analysis could have been correct merely by chance), the process involved in that analysis may be of interest, since the very same process applies to predictions for the remainder of 2014.

The following observations, based on large sample of historical performance of the S&P 500 over the past 10 years, in a wide variety of market environments (data is provided in charts that follow, for verification), are likely highly-accurate predictions for the remainder of 2014.

  1. The S&P, even in the most bullish scenario, will not exceed 2200 through the end of 2014.
    For verification, see the green line on the chart above, formed by a 4% Long Straddle profit, which serves as the upper limit of the S&P 500, as well as the chart of the LSSI below, showing how the 4% profit is almost never exceeded in an uptrend.
  2. The S&P will not fall below approximately 1850 as long as the current Bull market is in place, through the end of the year.
    For verification see the red line on the chart above, that divides Covered Call profits from Covered Call losses, as well as the chart of the CCNPI below, which shows how pullbacks and corrections tend to be much less severe when the CCNPI shows Covered Calls and Naked Puts are profitable, and more resemble a Bear market when those trades are not profitable.
  3. If the S&P falls below 1850 through the end of the year, it will likely fall a lot further.
    For verification, see the chart of the CCNPI below, which shows how, historically, the S&P tends to fall precipitously once Covered Calls and Naked Puts are no longer profitable.
  4. The S&P is likely to end the year on one of the colored lines (green, blue, yellow , orange or red) rather than in-between those lines, if a Bull market is still underway.
    For verification see the link to the 10-year chart of the Options Market Stages earlier in this analysis which shows the propensity of the S&P to hug the lines that divide the Options Market Stages.
  5. The most extreme environment the S&P could endure without entering a Bear market, would be a rally to 2150 in October followed by a post-U.S. election correction all the way to 1850 in November; or a correction to 1850 in November followed by a Santa rally all the way to 2200 by Christmas.
    For verification, see the green line and the red line on the chart above, as well as the charts of the LSSI and CCNPI below, which show the limits of a Bull market.
  6. The 2000 level for the S&P will no longer convey feelings of extreme bullishness among traders once the first week of September has passed. In fact, traders will quickly become fearful of S&P 2000 by the time October rolls around. Talk of range-bound prices, topping patterns  (double-top, head and shoulders, broadening formations, etc.) and historic October crashes will abound at S&P 2000, even though that same level made bullish headlines several weeks earlier in August.
    For verification, see the yellow zone on the chart above as well as the descriptions of Bull Market Stage 3.
  7. The VIX will likely soar to 25 or higher, for the first time in a long time, unless the S&P climbs much higher, from its present level near 2000, by the end of the year.
    For verification, see the orange zone on the chart above as well as the descriptions for Bull Market Stage 4.


Although each of the above predictions does not contain an exact statement of the expected accuracy, relevant data has been provided for the reader to assess the accuracy independently. It may be helpful to consider each prediction to be correct beyond a reasonable doubt, rather than attempt to calculate a fixed percentage. Certainly there is a shadow of a doubt for each prediction, as nothing in the future can be 100% guaranteed, not even tomorrow’s sunrise. In any case, with so many unknowns in the stock market, it can be beneficial to look at the knowns from time to time.

 

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 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, nearly 3 full years later, in 2014.

As long as the S&P remains above 1826 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. Below S&P 1826 this week, Covered Calls and Naked Puts will not be profitable, and since such trades only produce losses in a Bear market, it would suggest the Bears were 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.

•           “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

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

As long as the S&P closes the upcoming week above 1929, Long Calls (and Married Puts) will remain profitable, suggesting the Bulls retain confidence and strength. Below 1929, Long Calls and Married Puts will not be profitable, which would suggest a significant shift in sentiment, notably a loss 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 set recent highs as brick-wall resistance, since each test of that high is perceived as a rip to be sold.

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 +1.0%, which is unusually high, but still normal (below 4%), 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. Positive values for the LSSI represent profits for Long Straddle option trades. Profits represent an unusual condition for Long Straddle trading, 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)

Long Straddle trading (and Long Strangle trading) will not be profitable during the upcoming week unless the S&P closes above 1980. Values above S&P 1980 would suggest a continuation of the recent euphoric “lottery fever” type of mentality that tends to lead to a rally for stock prices.

Excessive Long Straddle trading profits (more than 4%) will not occur unless the S&P exceeds 2055 this week, which would suggest absurdity, or out-of-control “lottery fever” and widespread acceptance that stock prices have risen too far too fast for the rate to be sustainable, thus needing to correct in order to return to sustainability.

Excessive Long Straddle losses (more than 6%) will not occur unless the S&P falls to 1867 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 break higher from 1867 would be a major bullish “buy the dip” signal, while a break below 1867 would signal a full-fledged Bull market correction was 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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