By Chris Ebert

Try this – without looking at a chart, is the S&P 500 best described as being in a strong uptrend, a rally under pressure, a weak downtrend, a significant pullback, or a Bull-market correction?

How far back in time did you go to make your determination? How long is your personal stock-market attention span; a few days, months, years? The following analysis suggests the most common attention span is about four months.

stopwatchCollectively, the stock market is preoccupied with the past four months, the past 100 days or so only. Memories beyond four months ago tend to fade away. More recent developments, for example the past few days, tend to be disregarded if they don’t agree with the trend over the past four months.

As far as traders are concerned, anything that happened more than 4-months ago is ancient history, and anything that has happened in the past 4-months is random noise if it does not agree with the 4-month trend.

Take the 2014 New Year’s Eve sell-off, for example. It did not agree with the strong uptrend in place since August, 4-months earlier. The hackneyed response for many was to “buy the dip”, since the dip does not agree with the current 4-month trend.

Stock Market’s Attention Span

The market’s focus on 4-month trend is evident when one looks at the significance of the 100-day simple moving average. Quite simply, the 100-day moving average gives a rough estimate of the current 4-month trend; prices above it mean the trend is up, below it the trend is down.

While it is possible for a trader to survive using nothing but the 100-day moving average as a guide, the signal it gives tends to be black and white. Let’s face it; nothing about the stock market is truly black and white. That’s the reason for the proliferation of so many other stock market indicators. Nonetheless, the 100-day moving average stands as one of the most important indicators of the collective sentiment of traders, despite its inability to see colors.

The following analysis builds on the importance of the 100-day simple moving average. Rather than just plainly stating in black and white whether the trend is up or down over the past 4-months, which is what the 100-day average basically does, the following analysis goes a step further. Presented here is a view of the market, in living color.

Here, the expectations of traders are analyzed in order to give the market a sort-of letter grade, rather than the simple pass or fail grade one would expect from the 100-day average. And, what better way to gather data regarding traders’ expectations than to study the options market. After all, option premiums are based upon expectations. Thus, the performance of options at expiration is a perfect way to see what expectations the market is exceeding, and which expectations are being dashed to bits.

Since the market seems concerned mostly with the past 4-months, it stands to reason that 4-month options will give the best picture of the current market. That is to say, if one studies options on their expiration day, that are opened 4-months prior to their expiration, one will see whether expectations have been met.

3 Option Strategies – 8 Possible Outcomes

Using one option strategy, there are two possible outcomes, black and white. If the strategy is profitable, expectations have been exceeded, if it is not profitable, they have not. Using two option strategies, there are four possible outcomes, black, white, and shades of gray. Using three option strategies, there are eight possible outcomes that define in great detail – in full color – how the stock market is currently meeting trader’s expectations.input

The following analysis uses three simple option strategies on the S&P 500 index, thus there are eight possible outcomes. A select few of the outcomes can occur in more than one type of stock market environment, so the number of possible outcomes including duplicates is eleven.

There are 11 colors to the stock market – 11 types of trading environments. Each environment has its own distinctive character – its own emotions – and its own reaction to economic news.. Pinpoint the environment, and whatever emotions are present will likely make sense.

Using Options to Predict Emotions

The effect that any economic news will have on the market cannot be known, because the news has not happened yet. However, it is quite possible to predict quite accurately the emotions that traders will feel, collectively, at any given moment.

If the emotions are known, predicting how the market will react to the news becomes a rather simple exercise. There are markets in which irrational exuberance allows traders to buy stocks and send prices higher, even in the face of bad news; and there are markets so bleak that seemingly great economic news cannot push folks to buy stocks. It all depends on whether the market is meeting or exceeding expectations. It all depends on option performance.

The following analysis saves a trader all the hard work. All the S&P 500 trading environments, past, present, and several months into the future, have been clearly calculated and defined here. This can be extremely useful for a trader who does not personally use stock options, perhaps does not fully understand the options market, or simply does not have access to the required options data.

Each week, an Options Market Analysis of the S&P 500 is presented here in order to give traders an edge in the market, not by trying to predict the news, but by helping traders predict the emotional reaction to any news. This week, the stock market is in a zone known here as Bull Market Stage 2.

Stocks and Options at a Glance 01-02-15

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 – 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 January 2, 2015, 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 +2.9%.
  • Long Call and Married Put trading are each currently profitable (B+).
    This week’s profit was +0.7%.
  • Long Straddle and Strangle trading is currently not profitable (C-).
    This week’s loss was -2.2%.

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.

Trading in the Zone

The S&P 500 spent much of 2014 in the same zone as it is today – Bull Market Stage 2. As can be seen on the chart of the Options Market Stages, when Stage 2 is underway the S&P 500 tends to be drawn to the blue line like a magnet. That’s no accident.

The blue line separates a normal Bull market (Stage 2, the blue zone), in which economic news has a strong effect on stock prices, from an irrationally exuberant Bull market in which economic news takes a back seat to the news of the skyrocketing stock prices themselves (Stage 1, the green zone).

Traders are wary of irrational exuberance by nature; after all, it is irrational. It is not natural for the stock market to enter Stage 1. But when it does, get out of the way! There is no fighting Stage 1 rationally, since it is by definition fueled by irrationality. But, the market tends to stave off Stage 1 as long as it can, thus the normal tendency for healthy Bull markets to hug the blue line whenever possible.

The yellow line separates a normal Bull market (Stage 2, the blue zone) from one experiencing a serious lack of confidence (Stage 3, the yellow zone). Weakness brings panic, and panic causes many weak hands to sell their stocks into strong hands. Once weakness sets in, it is difficult to dislodge.

The only thing worse than being forced to sell stocks during a downturn, is watching those stocks rebound right after they have been sold. Weak hands that sell stocks during Stage 3 are therefore less likely to buy stocks if prices rebound back to Stage 2.

The effect of Stage 3 is that it creates a brick wall of resistance, often lasting for at least several weeks, at a level of the S&P that was a recent high in the weeks immediately preceding the dip into Stage 3.

OMS 01-02-15

Weak hands are reluctant to enter the market on new highs after having sold out on the lows of Stage 3. Strong hands therefore have the entire burden of driving stock prices higher by themselves – not an impossible task, but not easy by any means. It is much easier to drive stock prices higher if weak hands are just as enthusiastic to buy as are the strong hands.

The blue zone is therefore often the best zone for a trader who likes to buy the dip. As long as the S&P 500 stays within the blue zone, Stage 2, the market is nothing but blue skies. Not surprisingly, the blue zone also bodes well for long-term buy-and-hold investors. Whenever the S&P 500 moves out of the blue zone, traders should take note.

A move into Stage 1 (the green zone) is generally unsustainable for more than two months, so traders may do well to protect profits once the S&P enters Stage 1. Rallies can be amazing during Stage 1, so it is important to avoid the temptation to take profits too early. A better alternative is often to protect stocks with Put options during Stage 1, since extremely low implied-volatility tends to make options very affordable during Stage 1. Stage 1 means the rally is almost done. Cheap Put options allow stocks to profit in the rally, without giving up all the gains a few months later when the rally ends… as it always does.

A move into Stage 3 (the yellow zone) is perhaps more unsustainable than any other move the S&P 500 can make. Stage 3 rarely lasts more than a week or two. Once the S&P sinks below the blue zone into the yellow zone, Stage 3, the following weeks tend to bring violent moves in the market; either a violent snap-back rally or else a full-blown violent “Bull-market correction” Stage 3 is not a good place for the S&P to be. Stage 3 does not last.

Knowns and Unknowns for Early 2015?

The S&P 500 already dipped into the yellow zone several weeks ago. This has likely caused a brick wall to develop, as evidenced by the recent pullback upon reaching all-time highs near the 2080 level. If it pulls back into the yellow zone again, already weakened hands (due to the previous pullback into the yellow zone in December) are likely to become even weaker. That could potentially make for a market on the edge of its seats.

A dip into the yellow zone, Stage 3, would occur in the next few weeks (below approximately the 2064 level on the S&P through January 10, or below about S&P 2000 by the end of this month). As noted above, the yellow zone is unsustainable for more than a week or so. Should the S&P dip into, say, into the 2050s next week, or into the 1900s by month’s end, into the yellow zone, Stage 3, it is very unlikely to stay there. It will either rebound violently, back to new highs, or it will sell-off violently, lower than it’s been in several months.

The tendency of the S&P to leave Stage 3 quickly after entering is evident on a long-term historical chart of the Options Market Stages.

Options Market Stages 2005 to 2014

Click on chart for larger full-resolution version

A spike into the green zone, Stage 1, would occur in the next few weeks (above approximately the 2110 level on the S&P through January 10, or above about S&P 2070 by the end of the month). As noted above, the green zone is generally unsustainable for more than a couple of months. Should the S&P rise above 2110 next week, into the green zone, Stage 1, it is very likely that the rally will then take it much, much higher, but with the caveat that such a rally will likely be followed by a significant pullback. The green zone doesn’t last forever, unlike the blue zone which can theoretically continue indefinitely; and sell-offs that occur in the green zone tend to occur quickly, often without explanation.

If the S&P remains in the blue zone, Stage 2, over the coming weeks, it’s likely to be the same old, same old type of market. No real progress is likely in stock prices, either higher or lower, as long as Stage 2 remains in place over the next several weeks. The emotional effect of any news is likely to be temporary as long as Stage 2 is in effect. The market could become uncommonly quiet if Stage 2 continues.

News gets digested during Stage 2. Bad news causes pullbacks that last a few days, and then the market digests the bad news and moves on to higher prices once it finds support. Good news causes rallies that last a few days, but the market tends to digest the good news after a few days and profit-taking sends prices back towards where they were before the good news. Only when the news causes the S&P to deviate from Stage 2 does it have any lasting effect.

S&P 2100s

Traders should therefore be on the lookout for two things this January of 2015. News that sends the S&P into the 2100s (green zone) could be the primer that sets off a case of Lottery Fever. Irrational exuberance is likely to fuel an impressive New Year rally if something or someone pushes sock prices high enough, and S&P 2100 is currently the tipping point at which Lottery Fever would take hold. That’s a known variable.

S&P 1900s

Traders should also be on the lookout for a dip this January 2015. News that sends the S&P into the 2050s or below (yellow zone) in early January or below the 2000 level by late January could be the spark that sets off a major correction, the likes of which have not been seen around these parts for several years.

Since the S&P does not often stay in the yellow zone for more than a couple of weeks, such a correction would be likely to occur within two weeks of entry into the yellow zone, if it were to occur. Entry into the yellow zone does not guarantee that a correction will occur, but a correction will almost always occur within two weeks if it is going to occur at all. That’s a known variable.

The Unknown

Nobody knows what the news will be over the coming weeks. Nobody knows what world events will make headlines. Nobody knows how corporate earnings will play into the equation. But, it is well known how the herd will react to the news. The reaction will be quite different depending on whether the S&P 500 is in the green zone (Stage 1) the blue zone (Stage 2) or the yellow zone (Stage 3).

Summary

For the week of January 4 through January 10, 2015:

  • Stage 0 Disappearing Fear will be present this week between S&P 1997 and 2064, but only if it immediately follows Stage 5, otherwise this range is Stage 3, shown below
  • Stage 1 Lottery Fever will be present this week between S&P 2118 and 2198
  • Stage 2 Digesting Gains will be present between 2064 and 2118
  • Stage 3 Resistance will be present between 1997 and 2064
  • Stage 4 Correction will be present between 1957 and 1997
  • Bull Market Stage 5 All Clear will be present if the S&P bounces higher after Stage 4
  • Bear Market Stage 5 Oh No! will be present between 1903 and 1957
  • Bear Market Stage 6 Phew! will be present if the S&P bounces higher after Bear Market Stage 5
  • Bear Market Stage 7 Look Out Below will be present between 1903 and 1957, but only after a major dead-cat bounce, i.e., after Stage 6, otherwise this range is Bear Market Stage 5, shown above
  • Bear Market Stage 8 Bleak Outlook will be present below S&P 1823
  • Bear Market Stage 9 Bargain will be present when Covered Calls first become profitable after Stage 8 has been reached, i.e., after S&P 1823

Seeing the stock market in color may allow a trader to more effectively take advantage of opportunities. Instead of black and white, instead of being simply all-in the market or all-out, a trader can be in the market to a degree, or out to a degree, depending on the environment.

Note: for clarity, the Bear-market Stages have been omitted from the charts above, and only Stages 1 through 5 are shown. For an example of the Bear-market chart see the Hitchhiker’s Guide to Bear Markets.
 
Note: there is no Stage with a higher range for the S&P than Stage 1 Lottery Fever. The S&P 500 has an upside limit that cannot normally be exceeded. For further information of the upper limit of the Lottery Fever stage see Proof S&P Won’t Top 2050 Through August
 

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 01-02-15

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 within the following four months… through the end of February 2015. 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 1957 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 1957 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 01-02-15

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 2064, Long Calls (and Married Puts) will retain profitability, suggesting the Bulls have retained confidence and strength. Levels above 2064 would suggest a continuation of recent sentiment, notably confidence by the Bulls. Below 2064, weakness and a lack of confidence should be abundantly 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 01-02-15

The LSSI currently stands at -2.2%, which is normal and not a level of concern, as it is indicative of a market that has neither become overly 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 2118. Values above S&P 2118 could only occur during an irrationally exuberant Bull market. Values above 2118 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 2198 this week. Values above 2198 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. 2198 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 1997 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 1997 would likely bring a violent snap-back rally or else a violent resumption of the most recent downtrend. The 1997 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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