By Chris Ebert

Nobody, not even the most seasoned expert with the most extensive analysis, knows for sure who will win next week’s Super Bowl football championship. And not even the best trader in the world can say for sure where the stock market is going next week.

What is known is how the winners will feel, and also how those watching from the sidelines will feel. In that respect, the winners of a sporting event are no different than winners in the game of trading stocks. Understanding those feelings can make or break a trader in the stock market.

underdogFeelings not only depend on winning or losing, but whether a win was the expected outcome or whether it represents an upset. Take the classic announcement, “The Giants win the Pennant, the Giants win the Pennant!”, when the team won against all odds. That’s just how traders feel when their team, the Bulls or the Bears, come from behind to win in the stock market.

The basic problem that every trader faces comes down to this: choosing a side in the stock market is dangerous, because the chosen side is always at risk of losing. Yet, how can one trade without picking a side?

The answer:

  • Choose the side that’s winning; and be ready to switch sides in an instant.
  • Don’t be a Perma-Bull or a Perma-Bear; be a Bull when the Bulls are winning; be a Bear when the Bears are winning.
  • Most importantly, be ready to switch sides quickly when the underdog wins.

Combined with healthy risk-management and proper position sizing, that’s really, truly, all there is to being a good trader – being on the winning side. So, all that’s necessary is to find a method of determining who is winning.

While no method is perfect, and there are times when the winner can be difficult to determine by any means of analysis, there are other times when the winner is clear – particularly after a victory by the underdog. If a trader does not know which side to choose, waiting for an underdog moment can be enlightening.

Underdog moments happen all the time in the stock market. An analysis of the options market, as the analysis that follows, is one way reveal those moments.

The premise is rather simple; there are 11 Stages the stock market can go through. When the market enters a new Stage (as measured by a broad index of stocks such as the S&P 500), it represents a new victory for either the Bulls or the Bears. Sometimes the victory is expected, and indicates nothing more than confirmation that the side everyone though was in control, is still in control. Other times it’s an upset.

The analysis, which is presented right here each weekend, begins as always with three simple option trades, determines which of those trades are profitable and which are not, and then uses the profit or loss to determine the current Options Market Stage.

 Stocks and Options at a Glance 01-24-15

* 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 24, 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 +3.2%.
  • Long Call and Married Put trading are each currently profitable (B+).
    This week’s profit was +1.1%.
  • Long Straddle and Strangle trading is currently not profitable (C-).
    This week’s loss was -2.1%.

    Options Market Stages
    Click on chart to enlarge

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 punctuated by relatively minor pullbacks or consolidation, the breaks in the uptrend being the market’s way of digesting each successive gain.

The chart at right shows the general market environment for Stage 2 in comparison to all of the 11 Options Market Stages.

This week’s winner is…

As can be seen on the chart below, the S&P 500 moved up to Stage 2 this past week, from Stage 3 the previous week. That’s obviously a victory for the Bulls. Whenever the S&P moves to a higher Stage on the chart, it is a victory for the Bulls; a lower Stage is a victory for the Bears.

Generally, the market enters a new Stage several times per year, usually once every month or couple of months. The new Stage either confirms whether the winner is a victory for the current trend, for example a victory for the Bulls in an ongoing Bull market, or else it signals a victory for the underdog.

This past week saw the Bulls claim victory in what has been an overall-bullish market for the past several years. The Bulls were the expected winner, not the underdog. As a result, the celebration of that victory has been relatively subdued, quite a contrast from the explosive celebration which occurred this past October when the Bulls took back control of the trend in a bearish environment – when the Bulls were the underdog.

OMS 01-24-15

As long as the S&P 500 is in a bullish Options Market Stage, the Bulls are the favored winner and the Bears are the underdog. Only when the S&P enters bearish zones (red area on the chart) do the Bulls become the underdog. That’s exactly what happened in October 2014, and the subsequent celebration of the bullish win seemed to scream “The Giants win the Pennant!”

Bears are now the underdog

As has been the case quite often in recent months and years, the Bears are the underdog in this stock market. It does not mean the Bears cannot claim victory, just that they are fighting an uphill battle at the moment.

In order for the Bears to claim a victory in the coming weeks, they will need to drive the S&P 500 into a lower Stage. Since the market is currently at Stage 2, the Bears would need to push it down into Stage 3 for a victory.

Many times, entering a new Stage requires a move of as little as 1% or 2% for the S&P. However, at the moment, Stage 2 is unusually wide. The distance from the top of Stage 2 (the minimum point at which Long Straddle trading is profitable) and the bottom of Stage 2 (the minimum point at which Long Call trading is profitable) is approximately 100 points, or 5% of the S&P.

The stock market can rally and push the S&P as high as about 2080 without entering a new Stage, and it can sell-off all the way down to about 1980 without entering a new Stage. As long as the S&P 500 stays between 1980 and 2080 in the next week or so, neither the Bulls nor the Bears will be able to claim any significant victory.

The implications for anyone who is undecided at the moment, and does not know which side to choose – Bulls or Bears – is that it could be difficult to take a trade through the end of January unless the S&P touches either 1980 or 2080. It is true that the Bulls scored a victory this past week, pushing the market up into Stage 2, but that opportunity has passed.superbowl

The time to take advantage of the bullish victory was the moment the market crossed into Stage 2. While that victory is a confidence-booster for the Bulls, and may lead to higher stock prices in coming weeks, the victory party has ended. Although bullish confidence could potentially lead to higher prices, the market could also take an opportunity to digest recent gains, leading to lower prices.

For an undecided trader, now might be a time to wait patiently. Options Market Stages tend to change several times a year, so the next change may only be a few weeks away. Patiently waiting for a change to Stage 1 “Lottery Fever” would be like waiting for the Bulls to claim another victory. Waiting for Stage 3 “Resistance” would be like waiting for the Bears to come from behind to win as the underdog. Lastly, waiting for Stage 2 “Digesting Gains” to be confirmed by a bounce off the limits of either Stage 1 or Stage 3 would be like waiting for confirmation of the status quo – a continuation of the current Bull market trend.

There will be no victory parties through February 1 unless the S&P hits either the 1980 level or the 2080 level. The only victory in the next week could very well be for the Super Bowl champions. Predicting the next stock market victor is as impossible as predicting the Super Bowl. Joining the championship party can be just as simple. But it requires waiting for a champion to emerge.


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 01-24-15

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 2014 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 approximately 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 1817 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 1817 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 01-24-15

Long Call trading losses ensued several weeks ago, a major sign of a lack of bullish confidence and strength. While Long Call losses by themselves are not a sign that the Bears have taken control, the loss of confidence that occurs when Long Call trading is unprofitable can quickly reveal underlying bearish tendencies unless a sustained rally occurs within a few weeks.

Once Long Call losses are occurring, a propensity for profit-taking often sweeps over market participants – a propensity that generally lasts for at least several weeks. If a Bull market can endure this propensity without suffering a major correction, it can be strong indicator of future growth in stock prices. A market with bearish tendencies can rarely endure the added burden of a widespread propensity for profit-taking, at least not without suffering a major pullback or correction.

Long Call profits returned this past week, but it could take several weeks before the propensity for “selling the rip” disappears.

If the S&P manages to close the upcoming week above 1995, Long Calls (and Married Puts) will retain profitability, suggesting the Bulls have retained confidence and strength. Levels above 1995 would suggest a continuation of recent sentiment, notably confidence by the Bulls. Below 1995, 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 01-24-15

The LSSI currently stands at -2.1%, which is normal and not a level of concern, as it is indicative of a market that has not become overly range-bound (and therefore nearing a level at which it is “due for a breakout” from the range of the past few months) and it is also not over-extended (and therefore nearing a level at which it is “due for a correction”). Instead, it is normal (neither in dire need of a breakout nor in need of a correction).

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, a breakout is becoming more likely to occur on its own accord, perhaps even without any sufficient news catalyst, because the LSSI is becoming abnormally low. 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 not abnormally high. 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 2093. Values above S&P 2093 could only occur during an irrationally exuberant Bull market. Values above 2112 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 2172 this week. Values above 2172 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. 2172 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 1975 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 1975 would likely bring a violent snap-back rally or else a violent resumption of the most recent downtrend. The 1975 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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