By Chris Ebert

Note to readers: The weekly updates of the S&P 500 options market are now presented here each Thursday evening. In-depth analysis of the options presented here will continue to be published each Sunday morning.

In the stock market, height is important. But, speed is even more important. If stock prices move too slowly, traders get anxious, even when prices are climbing to new highs. A rally without a little irrational exuberance can be a dangerous thing. Exuberance keeps fingers from hovering over the sell button. Exuberance keeps short sellers on their toes; quite simply, exuberance keeps the Bears away.

The S&P 500 nudged the 2100 level for the first time ever this week. At first glance, that could be considered to be quite an accomplishment; and in some ways it is just that. But such arbitrary milestones – psychologically significant round numbers such as 2100 – generally don’t have any long lasting significance, especially when there is a lack of exuberance.

What is significant is that such an accomplishment for the stock market does not currently include an accompanying accomplishment for many traders in the options market. Option traders, particularly Long Straddle* traders are not profiting from the rally to S&P 2100. Moreover, Long Call* traders are barely eking out a profit these days. Those traders should be rolling in money when the market makes new highs – but they’re not.

About the only option traders who are consistently earning a profit these days are Covered Call* traders, but they earn a profit in all but the most bearish environments. Two things are certain: unless Long Straddle traders begin to share the benefits of this rally, the rally will lack the very exuberance that makes rallies sustainable. And, if Long Call traders begin to lose what little profit that have managed to gather recently, the rally is likely doomed to fail from lack of momentum. A rally to new highs cannot live on Covered Call profits alone.

  • Bull Market Stage 1: If the S&P climbs above 2150 rather soon the increase in exuberance would add sustainability to the current rally.
  • Bull Market Stage 3: If the S&P falls below the 2100 area in the near future the lack of momentum could doom the current rally to failure.
  • Bull Market Stage 2: If the S&P remains in the 2100-2150 range through early March, the lack of enthusiasm could make long-term sustainability for the current rally iffy.

Stocks and Options at a Glance 02-19-15

* 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 week, as of February 19, 2015, this is how the trades are performing 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 +3.1%.
  • Long Call and Married Put trading are each currently profitable (B+).
    This week’s profit was +1.0%.
  • 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 are 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.

History of the Options Market Stages

The charts above depict the current state of the stock market. As shown on the charts, there are two very basic sequences of events, one for Bull markets, and one for Bear markets.

The progression for Bull Markets is very simple. It begins with Stage 0, then moves on to Stages 1, 2, 3, 4 and 5 at which point the whole process begins again at Stage 0. Such a progression is known as the Ebert Cycle of stock option performance.

Towards the end of a Bull market, the cycle tends to deteriorate, and becomes much less reliable. Interruptions in the normal progression of the cycle therefore deserve attention.

Cycle Interruption Reveals Big-Money’s Intentions

The reason for the significance of Long Straddle and Long Call traders not thriving in the current environment (not just the obvious significance to option traders, but for all participants in the stock market) is that Long Straddle profits indicate an element of surprise. No profit… no surprise. Indeed, the recent rally to 2100 should have surprised few traders.

Surely there will always be some folks who are surprised by the extent to which stock prices can climb. But, given the recent history of the S&P 500, reaching the 2100 level was not a particularly newsworthy event. After all, it stood at 2075 way back in November. Climbing those final 25 points to 2100 is laudable, but the fact that it took three months is more reminiscent of a car coasting down pit road for re-fueling than of a green flag at the Daytona 500.

So, either the market has just spent the last three months consolidating and getting ready for a really big rally, or else it has become exhausted. If the rally still has steam, it should stick to the blue line. Any deviation from the blue line means something is amiss.

Importance of the Blue Line

If the S&P is attracted to the blue line, as it should be if big money has any influence, then it should stick to the blue line rather soon and stay there over the next several weeks.

If the S&P is not attracted to the blue line, as it tends to be when big money is not wielding its influence, then the only thing holding the market up is that it is being repelled by the orange line.

OMS 02-19-15

A longer-term 10 Year History of the Options Market Stages is available.

The orange line always repels the S&P 500. It is one of the least sustainable environments for stock traders, so the orange line is a place the market avoids. A Bull market can be sustained for a time, simply by the fact that it does not want to go near the orange line.

When the market is dominated by big money – large institutional traders – those traders obviously will take whatever steps are in their power to avoid the orange line. They prefer the blue line, as can be seen on historical charts. When the market is dominated by individual retail traders, they also avoid the orange line at all cost, but individuals do not have the power to hug the blue line without the backing of big institutional support.

Thus, the S&P will always avoid the orange line, but it will only be consistently attracted to the blue line when large institutional traders are wielding their influence. Conversely, if the S&P is not consistently attracted to the blue line, big money is not using its power to support the market.

When big money is absent, the market may thus hover far above the orange line in order to avoid contact. Stock prices can and do rise, sometimes to all-time highs, without necessarily being backed by large institutional traders. But, unlike big money, retail traders are fickle. So, any catalyst can send stock prices towards the orange line; and if the S&P crosses that line, the repellant property of the line can push stock prices even further down, exacerbating a sell-off.

Individual retail traders, even collectively, lack the necessary dedication or ability to keep from avoiding the orange line if a sufficient catalyst acts on the market. Only big money has the ability to pull the market back from the abyss once it falls below the orange line.

The dependability and sustainability of a Bull market should be questioned if big money is not behind that Bull market with its full support. Such support is evident when the S&P 500 sticks to the blue line. Such support is questionable if the S&P does not stick. Without support, it’s just a matter of time until a sufficient catalyst wreaks havoc.

Who knows how many new highs the market could set between now and the time havoc strikes? But, when it does, watch out for that orange line!

Weekly 10-Minute 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. (Note: Italicized bold print identifies changes in the analysis from week to week.)

STEP 1: Are the Bulls in Control of the Market?

If the S&P falls below 1973 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 1973 next week, Covered Calls and Naked Puts would be profitable, which is normally a sign that the Bulls are in control.

How the #CCNPI works: 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

The #CCNPI is based on the premise that Covered Call trades are only unprofitable in a Bear market, particularly at-the-money Covered Calls representing a wide cross section of the stock market, and with reasonably distant expirations.

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 several 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 any rally is a trap. Even if it turns out not to be a trap, it is better to be safe than sorry.

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?

If the S&P manages to close the upcoming week above 2091, Long Calls (and Married Puts) will retain profitability, suggesting the Bulls have retained confidence and strength. Levels above 2091 would suggest a continuation of recent sentiment, notably confidence by the Bulls. Below 2091, weakness and a lack of confidence should be abundantly apparent.

Long Call trading profits resumed several weeks ago, after returning profits for the majority of 2014, a major sign of bullish confidence and strength.

How the #LCMPI works: 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

The #LCMPI is based on the premise that Long Call trades are only profitable during periods of profound bullish strength, particularly at-the-money Long Calls representing a wide cross section of the stock market, and with reasonable distant expirations.

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.

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, however, can rarely endure the added burden of a widespread propensity for profit-taking, at least not without suffering a major pullback or correction. Sustained Long Call losses are therefore a dangerous sign, because in the absence of a significant confidence-boosting event, the propensity to sell that accompanies Long Call losses is at the root of all Bear markets. So, while Long Call losses by themselves don’t generally cause a Bear market to evolve, they certainly reveal underlying bearish tendencies rather quickly.

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?

Long Straddle trading (and Long Strangle trading) will become profitable during the upcoming week only if the S&P closes above 2149. Values above S&P 2149 could only occur during an irrationally exuberant Bull market. Values above 2149 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 exceeds 2230 this week. Values above 2230 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. 2230 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 2027 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 2027 would likely bring a violent snap-back rally or else a violent resumption of the most recent downtrend. The 2027 level therefore divides an ordinary ‘pullback’ (above it) from a significant Bull-market ‘correction’ (below it). The 2027 level is currently on the ‘orange line’ of violence.

How the #LSSI works: 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

The #LSSI is based on the premise that Long Straddle trades are only profitable in a surprisingly overextended market, particularly at-the-money long Straddles representing a wide cross section of the stock market, and with reasonably distant expirations.

The LSSI currently stands at -2.1%, which is normal and not nearing a level of concern. It is indicative of a market that has neither 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, nor has the market become overly extended (and therefore nearing a level at which it is “due for 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 not likely to occur on its own accord, unless prompted by 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 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)

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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