By Chris Ebert

Last week, an analysis of options here presented evidence that the S&P 500 would not climb above the 2050 level through at least the end of August. As always, every attempt was made to offer facts, not opinions. Facts give traders a real edge; opinions provide nothing more than false confidence.

It is a fact, this week, that the S&P 500 is in the process of digesting its recent gains. With stock prices collectively up nearly 10% off the April lows, it is quite understandable that some traders may see an opportunity to adjust or re-balance their portfolios, likely selling some stocks to avoid the possibility of giving back all those gains.

An over-abundance of sellers results in some sellers not finding a buyer at their asking price. If those sellers insist on unloading their shares, they must lower their asking price to execute a trade. Other traders observe trades executing at lower prices and get spooked, causing them to put some of their own shares up for sale as well, in turn adding to the glut of shares for sale.

In a Bull market, like the current one, stock prices usually reach equilibrium quickly, since there are plenty of buyers willing to buy the dip. The stock market needs time to digest gains – time to reach equilibrium – time to put stocks in the hands of bullish “buy the dip” traders and take them out of the hands of nervous traders sitting on huge unrealized gains.

Without digestion, nervous owners would have difficulty pushing stocks to new highs, hampered by their urge to take profits. Buy-the-dippers aren’t nearly as nervous; so, digestion is actually a necessary part of a healthy stock market. It is true that digestion run amok can cause major pullbacks, corrections, and yes, even Bear markets. However, the following analysis will show that for now the S&P is digesting gains, only this and nothing more, quoth the options.

Stocks and Options at a Glance 07-12-2014

Click on chart to enlarge

*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 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 July 12, 2014, this is how the trades performed:

  • Covered Call and Naked Put trading are each currently profitable (A+).
    This week’s profit was +3.3%.
  • Long Call and Married Put trading are each currently profitable (B+).
    This week’s profit was +2.1%.
  • Long Straddle and Strangle trading is currently not profitable (C-).
    This week’s loss was -1.2%.

 

Options Market Stages

Click on chart to enlarge

* All profits are calculated at expiration, as a percentage of the underlying $SPY share price, using options ATM-when-opened 4 months to expiration (e.g.  Profit of $6 per share would represent a 3% profit if $SPY was trading at $200)

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 2, known here as the “digesting gains” stage because of it often accompanies a period of price consolidation, also known as digestion, following significant gains.

Stage 2 is bullish, but lacks the lottery-fever-like euphoria of Stage 1. It is more bullish than Stage 3 because it often is not limited by strong resistance to new highs, as often occurs with the “sell the rip” mentality of Stage 3. It is far more bullish than Stage 4, in which a correction often leads to a need to test  major support levels, for reassurance that those levels remain valid.

For a description of Bull Market Stage 1, as well as a comparison to all of the other market stages, see the chart on the left (click to enlarge):

What Happens Next?

Digestion is simply digestion… until it either ends (and the rally in stock prices resumes) or until it becomes something more. While anyone can offer an opinion about how this particular period of digestion will end, the truth is that nobody knows for sure. On the other hand, recognizing when digestion has ended can be accomplished quite accurately by analyzing some simple facts.

Ordinary digestion is rarely so severe or so long-lasting that it causes certain Long Call* option trades (* see description above) to suffer losses.

If stock prices fall so far that Long Call trades return losses, it’s often something more serious than ordinary digestion going on. Likewise, if digestion goes on for several weeks or months, decay in time value will eat up Long Calls to the point that they become unprofitable, again signaling something more than digestion taking place.

Like an oppressive summer heat wave punctuated by bouts of cool dry weather, the cool weather does not normally signal the end of the summer season but rather is analogous to a stock market digesting gains without affecting the overall trend. A single night of near-freezing temperatures or a few weeks of cool weather is often an indication of a change in seasons, a strong enough indicator that makes folks say “We’ll probably see snow before we see 30° again (85° F).” Absent such indications, there’s no reason to close up the swimming pool.

Digestion can usually be considered to have be completed when, in addition to Long Calls remaining profitable, previously unprofitable Long Straddle option trades become profitable once more.

It can be observed from the chart below that Long Calls would become unprofitable if the S&P was to decline below approximately 1900 – 1930 (the yellow line on the chart) through the remainder of July and into August.

A decline below the 1930-ish range would therefore be a strong indication that something more serious could be taking place. Below that range, strong brick-wall resistance would likely develop near the recent record highs if the S&P later neared those highs again. Brick walls develop when weakness scares traders into a “sell the rip” mentality. Further below, in the mid-1800s range  the dreaded “correction” environment always lurks (below the orange line) in which traders tend to seek reassurance that perceived support levels will hold, thus creating a sort of self-fulfilling prophesy in which prices actually fall to those support levels.   Below 1800, a true “Bear market”  would likely await (below the red line) in which no clear support level would exist.

As long as the S&P does not fall below that 1900 – 1930-ish range in the next month or so, there shouldn’t be much to worry about, because digestion would be occurring as expected; thus the S&P would likely resume the uptrend once the digestion process has been completed. That is a fact – a statement of probable outcomes based upon historical outcomes of such scenarios spanning numerous years of observations under a wide variety of stock market environments. All such observations are presented, immediately following this analysis, in charts of Long Call performance (#LCMPI) and Long Straddle performance (#LSSI) as each relates to performance of the S&P 500.

Options Market Stages 07-12-2014

Confirmation of digestion being completed is indicated by a return to Long Straddle profits, which would occur this coming week if the S&P topped 1975 (the blue line on the chart)

To summarize: Nobody knows whether the S&P will fall below the 1900 – 1930 range in the upcoming month or so, so any statement to that effect is an opinion. If such a breach indeed occurs, it would signal something more serious than ordinary digestion of recent gains in stock prices. Unless that breach occurs, though, it is probably safe to assume that the S&P is digesting gains, only this and nothing more, quoth the options.

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 07-12-14

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 1799 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 1799 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.

he 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 1917, Long Calls (and Married Puts) will remain profitable, suggesting the Bulls retain confidence and strength. Below 1917, 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.

LSSI 07-12-14

The LSSI currently stands at -1.2%, 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 1975. Values above S&P 1975 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 2050 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 1864 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 1864 would be a major bullish “buy the dip” signal, while a break below 1864 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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 Related Options Posts:

Proof S&P Won’t Top 2050 Through August

Selling Puts Vs. Buying Calls In Bull Markets

Beware – Options Rank S&P Rally C-Minus

 

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