By Chris Ebert

There are times when the stock market seems rather quiet, and other times when it just gets downright violent. While quiet conditions come when traders are in a relative state of consensus, violent times come from just the opposite – traders who are undecided and thus not in consensus.

One way of determining the state of consensus is through an analysis of stock option performance, particularly on $SPY or another broad-based ETF. There are only five basic outcomes if one opens an option trade on $SPY.

  1. Long Straddles, Long Calls and Covered Calls can be profitable, indicating overheated euphoria, a state of “Lottery Fever” (green)
  2. Long Calls and Covered Calls Can be profitable, but not Long Straddles indicating a market that is “Digesting Gains” (blue)
  3. Covered Calls can experience maximum profit, but not Long Calls or Long Straddles, indicating that the market has hit some resistance. (yellow)
  4. Covered Calls can experience less than maximum profit, indicating the market is correcting somewhat. (orange)
  5. Covered Calls can experience a loss, indicating market sentiment has turned bearish. (red)

Orange Line of Violence

Of those five categories, some are overtly bullish, others are easy to spot as being bearish. Those areas tend to allow a consensus to form more easily. But, it is the dividing line between them that often produces a lack of consensus. There is an area in which traders don’t know if this is the place to buy the dip, or if this is the beginning of the end and the time to unload their stock positions. That place very often occurs near the orange line on the chart.

There is nothing magical about the orange line. It just happens to have correlated historically many times with a lack of consensus whenever the S&P has neared it. Correlations are everything in this business. So, a trader who wants to be prepared for violent moves in the market could be more prepared for those violent moves by paying attention to the Orange Line of Violence.

The chart above depicts the S&P 500 as of June 28, 2016.

* Option strategies referenced above are analyzed for profit or loss on expiration day only and are opened using an at-the-money strike price, 4-months to expiration, using options traded on a broad-based ETF such as $SPY (NYSEARCA:SPY)

The preceding is a post by Christopher Ebert, Chief Options Strategist at Astrology Traders (which offers subscribers unique stock-trading perspectives and options education) and co-author of the popular option trading book “Show Me Your Options!” Chris 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

 

Related Options Posts:

S&P 500 Temperature Nearing Record Levels

Thursday Evening Options Brief 25-Feb-2016

Thursday Evening Options Brief 18-Feb-2016

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