By Chris Ebert
Last week it was explained here how an analysis of the performance of certain stock options was an historically accurate means of predicting the market’s reaction to economic news such as a possible “taper” announcement by the Fed. The performance of stock options reveals the current emotions of traders, and those emotions ultimately determine traders’ reactions to news.
“… if the reaction to the announcement is for traders to buy, fueled by the decrease of future uncertainty, then the S&P could test the upper limits of lottery fever.”
Bull Market Stage 1, also known here as “lottery fever” is a stock market dominated by rising prices. When stock prices rise, certain types of stock option trades become profitable.
- A. Covered Call trading is profitable whenever stock prices rise, no matter how small or how slow the increase in prices.
- B. Long Call trading is not profitable for small or slow up-trends, but becomes very profitable when the trend has strengthened.
- C. Long Straddle trading is only profitable during the strongest trends.
Currently, all three types of option trades are profitable. Using a plus (+) for profits and a minus (-) for losses, the performance of the above option trades this past week was A+, B+, C+. On the chart below, it can be seen that A+B+C+ occurs when the stock market is at Stage 1.
When Bull Market Stage 1 lottery fever is underway, traders tend to see the silver lining of every cloud. This widespread euphoria doesn’t just cause traders to enter the stock market form the sidelines in order to buy stocks; it also tends to make those who already own stocks less willing to sell. The result is that stock prices tend to continue rising, even after they have risen substantially.
But there is a limit to how quickly stock prices can rise, and penalties for disobeying the limit, as detailed in the following analysis.
*All strategies involve at-the-money options opened 4 months (112 days) prior to this week’s expiration using an ETF that closely tracks the performance of the S&P 500, such as the SPDR S&P 500 ETF Trust (NYSEARCA:SPY)
You Are Here – Bull Market Stage 1
In general, a healthy Bull market may produce profits on Long Straddle trading from time to time. To some traders, a Bull market in which Straddles are profitable may seem overbought. However, “overbought” can sometimes be difficult to define, not only because it implies that the majority of market participants have over-optimistically erred in their interpretation of the market, but because the technical indicators involved in such an analysis can be tough to comprehend.
Yes, there are indicators such as the Relative Strength Index (RSI) that can help pinpoint an overbought market; but for those who have difficulty visualizing a connection between stock prices and the RSI, there is an alternative – the Long Straddle/Strangle Index, or LSSI.
A market may not be truly overbought, from the perspective of a Long Straddle option trader, unless a rally comes as such a surprise that it leads to a gain of more than 4% in 4 months. To understand why, it may be helpful to consider the performance of the trade from the seller’s point of view.
A seller is free to charge as little or as much for a Straddle as the market will bear. While a seller may be willing to risk a small loss on the trade, a loss of more than 4% in 4 months is not something that can be tolerated on a regular basis. Sellers, as a group, have become quite adept at setting the premium for Straddles. In fact, they have become so adept that Bull-market losses of more than 4% in 4 months have occurred only a handful of times in the past 10 years.
Is stands to reason, therefore, that any Long Straddle gain exceeding 4% in 4 months is a red flag for traders. Who wants to be long stocks at a time when a rally has become so absurd that is among the handful of times that it has surprised savvy sellers of option Straddles?
The Long Straddle/Strangle Index (LSSI) analyzes the profit and loss of these trades and is published here regularly in order to provide an edge in the market to any traders who are interested. Being alerted to an LSSI exceeding 4% is just one of many ways traders may find an edge. Similar LSSI levels have often been followed by pullbacks in the S&P; and while the current LSSI has not yet reached 4%, it is getting close enough to deserve attention. As little as another 20 to 40 points on the S&P in the next week or so could push the LSSI above that important 4% level.
What Happens Next?
Bull Market Stage 1, in spite of tapping deep into the emotion of greed among traders, can theoretically continue indefinitely. As long as the S&P remains between the green and blue lines in the chart below, Stage 1 may continue uninterrupted. Such a scenario can become very frustrating for those who contend that Stage 1 represents an oversold market, since it may lead to waiting for a pullback that might not occur anytime soon. Stage 1 can also be a source of frustration among those looking to call a market top, since it often provides some of the signs of a top while subsequently continuing to set new highs.
For a complete description of all Option Market Stages, click here.
What happens next depends on which, if any, line in the graph is violated first.
- If the S&P climbs above 1840 – 1860 (green line) in the last two weeks of 2013, then it would likely push lottery fever beyond its upper limit. Historically, violation of the upper limit has been followed by either a quick pullback or several weeks of sideways trading to alleviate the overbought condition (See recent examples in Feb and May in the graph above, or historical examples in the past 10 years on the graph of the LSSI below.)
- If the S&P falls below the 1770 – 1790 (blue line) range in the final two weeks of 2013, then it quite possibly could represent the very beginnings of the path to a true Bull-market correction.
- If the S&P remains between 1770 and 1860 (blue and green lines) through the end of 2013, it would be conducive to a continuation of the current Bull market into early 2014, based on historical performance.
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.
This past week, Covered Call trading and Naked Put trading were both profitable, as they have been for an extended period. Covered Call trading has not yet experienced a single loss in 2013, 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 today. As long as the S&P remains above 1597 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. 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.
Long Call trading has been profitable for most of 2013 except for a brief break from August through early October. As long as Long Call trading remains profitable, as it did this past week, the Bulls will retain confidence and strength. That very confidence is what has allowed new records to be set for the S&P. Only if the S&P closes the upcoming week below 1713 will Long Calls (and Married Puts) fail to profit, suggesting the Bulls have lost confidence and strength. 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.
The LSSI currently stands at +0.6%, which is higher than average, but well within normal limits. Such levels suggest that option traders have had a good handle on predicting the future. Excessive profits on Long Straddle trades, such as those exceeding 4%, will not occur this coming week unless the S&P exceeds 1837. Anything higher than that is likely to result in some selling pressure, and historically has been associated with subsequent Bull-market corrections. Excessive losses on Long Straddle trades, such as those exceeding 6% will not occur this coming week unless the S&P falls to 1671. At or near that level a subsequent breakout is likely. 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.
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