By Chris Ebert

Last week’s market analysis concluded with a simple observation “… a move to 1988 or 1935, at any time in the next week or so, would be quite natural.”

Well, it’s now evident that the market chose 1988, not because that level is somehow magical, but because it represents a boundary between two different types of trading environments, just as 1935 represented a boundary.

Above 1988 is a zone known here as lottery fever for its feverish buying of stocks that drives prices higher without regard for fundamentals, economic news, or anything else that otherwise might cause prices to decline. Below 1988 is a zone of digesting gains, named for its methodical, rational consideration of economic developments that causes stock prices to take one step back for every two steps forward.

Although the S&P 500 closed a hair inside the lottery fever zone this past Friday, true lottery fever cannot be confirmed to have infected the stock market until the S&P has remained in that zone for at least a week. Every attempt to enter the lottery fever zone so far in 2014 has failed within a week. Therefore, if the S&P confirms lottery fever next week, it would likely indicate a major shift to bullishness, the likes of which have not been seen since 2013.

The last confirmed case of lottery fever began November 17, 2013 and ended on January 19, 2014. During that 2-month period, the S&P added nearly 100 points, which is not all that impressive a move on its own, but certainly is impressive considering it was on top of a 100 point move it had already made in the previous 2-month period from last September to November.

The following analysis is intended to help traders recognize and understand lottery fever, and thus avoid being unnecessarily frightened away from stocks just because indicators such as the RSI say stocks are overbought.

Stocks and Options at a Glance

click on chart to enlarge

* All profits are calculated at expiration, as a percentage of the underlying SPY share price. SPY is an ETF that closely tracks the performance of the S&P 500, specifically the SPDR S&P 500 ETF Trust (NYSEARCA:SPY). All options are ATM-when-opened 4 months (112 days) to expiration. (e.g.  Profit of $6 per share on a Long Call would represent a 3% profit if $SPY was trading at $200, even if 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 23, 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 +2.9%.
  • Long Straddle and Strangle trading is currently profitable (C+).
    This week’s profit was +0.0%.

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. Therefore, the coming week will likely either confirm (with S&P above 1985) or deny (with S&P below 1985) its presence.

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

Overbought Indicators are Not Always Reliable

The term overbought typically means that the price of a stock (or a basket of stocks such as the S&P 500) has gone too high to be sustainable. After all, there is no such thing as a stock literally being bought too much. There are only so many shares, just like any asset with limited supply.

For example, real estate can become overbought, but it doesn’t literally mean that too many folks bought property; with the possible exception of those who own land on a volcano, the amount of real property doesn’t increase. Overbought simply means that too many folks tried to buy at the same time; and with so many buyers available, sellers took advantage of the opportunity to raise their asking prices.

Overbought implies that prices will decline when the number of buyers returns to normal. But that’s not always the case. Not every increase in prices turns into a bubble that pops. Sometimes, conditions continue to appear overbought for an extended period of time, even when the volume of buyers declines.

If prices declined every time an indicator such as the Relative Strength Index (RSI) reached an overbought range, such as 70 or higher, there would be little need for a trader to use any other indicators; one could trade the RSI and get rich. Obviously, there’s more to being a successful trader than selling stocks when they reach their 70 RSI levels.

There is a reason the RSI works so perfectly at times, and other times fails miserably. That reason: the RSI, as is the case with many indicators, tracks changes in the stock not changes in the traders. Traders change.

Any technical indicator will fail

  1. If it assumes changes in stock price correlate to changes in the traders of the stock.
  2. If traders undergo changes that do not correlate to the price of the stock.Stock changes hands

Option Performance Tracks Changes in Traders

Traders often experience greed or fear that does not correlate directly with the price of stocks or the trend in stock prices. For example, traders may get actually get more greedy when prices seem overbought, not less greedy, as might be expected. Any indicator that fails to account for the increase in greed may perform poorly in such an environment.

More than a simple change in emotions, the traders themselves can actually change. In an extreme example, traders who own stock now, near all-time highs for many companies, are likely not the same traders who owned stock a few years ago, after the financial crisis had driven stock prices to multi-year lows. While less extreme, a lot of traders who bought stocks at the beginning of August, when the S&P dipped near the 1900 level, are likely not the same traders buying stocks now, closer to the 2000 level.

It takes a bullish trader to buy on a dip, it takes a really bullish trader to avoid the temptation to sell on the next rip, and it takes an irrational, greedy trader (or a highly- disciplined trend trader) to buy on the rip, after weeks of nothing but rips, even when that rip results in new all-time highs.

Thus, it is important to account for the possibility of irrationality when using any indicator. If irrationality spreads like a fever, like lottery fever, stock prices can then rise no matter how overbought they appear. RSI 70 is simply not as effective an indicator when lottery fever is underway.

Options Market Stages 2014-08-23

Essentially, if the S&P rises above the 1980s level anytime soon (through the first week of September), many folks buying stocks will be ignoring many traditional overbought indicators such as the RSI. That’s what makes the lottery fever stage so important for trader’s to recognize. Lottery fever makes prices go higher just when indications are that “they can’t go any higher”.

Lottery fever is irrational, and yet it infects the market occasionally; the whole market can and does become irrational at times. It may be helpful for a trader to consider who owns stock when lottery fever is underway. After all, stock is just a piece of paper (and in many cases just an electronic representation of a piece of paper); the stock itself doesn’t change much but the owners of the stock do change. Stock changes hands, which changes the value of the stock,  perhaps more than the fundamental value of the stock causes it to change hands.

Who buys stocks when lottery fever is underway (when at-the-money (ATM) Long Straddle option trades are earning a profit)?

  • The insane
  • Folks who only buy at all-time highs
  • Folks who buy on breakouts (Darvas boxes)
  • Short-sellers who buy to cover
  • Short-sellers who trigger a stop-loss or a margin call
  • Expiring out-of-the-money (OTM), when-opened, Call option owners (lottery tickets), now in-the-money (ITM)
  • Naked OTM, when opened, Call option sellers converting to Covered Calls, now ITM
  • Short Straddle option traders hedging losses
  • Buy and hold investors using a dollar cost average method
  • Those who are influenced by mainstream media headlines of rallies
  • Sideliners who get greedy or impatient
  • Angry traders who got stopped out on the previous dip and vowed not to let the stock market fool them twice (Stock Market Don’t Fool Me Twice)
  • Folks who recognize and embrace lottery fever, even if they hate it

Obviously, there is a limit to how high stock prices can go in a given period of time, no matter how irrational or insane the buying becomes. Over the next several weeks, the limit increases from approximately 2050 today to about 2100 by mid-September (green line in the chart above) and 2150 through much of October and November.

If lottery fever takes hold, and there is no guarantee it will, but if it takes hold it in the next week or so it would require a break above the 1980s level for the S&P. If such a break occurs, then it is likely the S&P would head towards one of the limits above, 2050 being the limit currently in effect. (Proof S&P Won’t Top 2050 Through August)

The stock market often gives off clues when it is making a shift to the lottery fever stage. These clues can be seen on a daily chart of the S&P 500 as a pattern resembling a cup and handle, bull flag or bull pennant, ascending triangle or wedge. In any of those patterns, the fact that stocks are changing hands is important to consider, especially the relative stability of the stock price throughout the process of the stock changing hands to extremely bullish traders such as those mentioned above.  Any traders in those groups would likely prefer to hold stocks, even through a minor decline, in order to profit from the anticipated continuation of the uptrend.  Thus, trading volume may tend to decrease as the stock changes hands.

Conversely, formations such as a double-top, head and shoulders or broadening formation are often signs that stocks are not changing hands, but remaining in the hands of those who are not bullish enough to handle a lottery fever type of trading environment. Lack of confidence may cause volume to increase as the stock does not change hands and those hands become impatient.

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 1825 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 1825 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 1932, Long Calls (and Married Puts) will remain profitable, suggesting the Bulls retain confidence and strength. Below 1932, 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 +0.0%, which is normal, 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 1985. Values above S&P 1985 would suggest a return to 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 2060 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 1872 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 1872 would be a major bullish “buy the dip” signal, while a break below 1872 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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