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.

Probably the most important factor an individual retail stock market trader needs to be concerned with at the moment is whether or not big-money interests are putting their support behind the most recent rally in stock prices – the rally that saw the the 2100 level surpassed for the S&P 500 index.

If big institutions and large investors are behind the current rally, it would behoove the individual trader to tag along. That’s because big money is likely to shore up stocks on any temporary sign of poor economic news, but only if it has skin in the game.

One way of discerning whether big money indeed does have a vested interest in the recent rally is to look at the performance of some simple stock options. As long as Long Calls* are profitable, it’s a pretty good bet that big money wants higher stock prices, and it will exert its best efforts toward that end. Long Calls are profitable only during Bull Market Stages 0, 1 and 2. At the moment, Stage 2 is in progress.

It is vitally important that all traders watch out for Bull Market Stage 3. If Stage 3 occurs, it could be a trader’s first warning that big money is not throwing its full support behind the recent stock market rally. Particularly important is the breakout rally above the long-standing 2090 level in the S&P 500, a level which had stood for several months as an unbreakable brick wall. The S&P has now exceeded 2100, leaving the brick wall behind.

Consider the possible reasons that big money might now allow Stage 3 to occur after having allowed the brick wall to fall.  The following weekly analysis describes ways of identifying Stage 3 as opposed to a continuation of the existing Stage 2, and some reasons each stage could occur.

 Stocks and Options at a Glance 02-26-15

* 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 26, 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 +2.9%.

    Options Market Stages

    Click on chart to enlarge

  • Long Call and Married Put trading are each currently profitable (B+).
    This week’s profit was +0.9%.
  • Long Straddle and Strangle trading is currently not profitable (C-).
    This week’s loss was -2.0%.

 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.

Why Would Stage 3 Occur Now?

Without large-scale support, individual traders are prone to sell on the first sign of weakness. For many, one such sign would be a reversal of the recent breakout in the S&P 500 above the 2090 level. For several months the 2090 area has stood like a brick wall.

Now that the brick wall has been broken as a level of resistance, it is important that it gets rebuilt as quickly as possible – rebuilt as a new level of support, not resistance. The faster it gets rebuilt, the quicker market participants will recognize it, and the faster the market can get on with the uptrend in stock prices.

Individuals should keep in mind that big money didn’t get so big by being stupid. Big money is smart money. Smart money knows that everyone and his brother is watching the recent breakout in the S&P for signs of weakness. Thus, it would actually be in the interest of big money to trick individuals into giving up their long stock positions, provided it still has skin in the game.

If big money truly intends to drive the S&P to new all-time highs this March, it should not surprise individuals that the first step might be to take out as many of the individual traders’ stops as possible.

Lots of traders likely have orders to sell stocks if the recent breakout above the 2090 brick wall starts to appear to be a false break. Big money certainly has the ability to give the appearance of a false breakout, simply by wielding its influence to temporarily take the S&P down below about 2090. Somebody needs to buy all those stocks when the stop-loss orders get tripped, and big money would surely be buying if the goal was to send stocks to new all-time highs. A dip slightly below 2090 on the S&P followed by a quick recovery would allow a individual to identify such a scenario as it was unfolding.

Big money has a vested interest in bringing the S&P 500 to the brink of Stage 3 if the intention is to resume the rally to all-time highs. Big money does not have a vested interest in going deep into Stage 3, because doing so tends to create a brand new brick wall of resistance. After all, that’s why Stage 3 is named the “resistance” stage, because it precedes brick walls of resistance.

OMS 02-26-15

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

Big money doesn’t necessarily benefit from a brick wall, so there is likely no compelling reason to bring the S&P deep into Stage 3 at the moment – just to the brink of Stage 3 – just enough to fool all the bullish traders into selling their stocks too early.

Watch Out for Traps near S&P 2090

The individual trader is thus left to observe whether the S&P dips into Stage 3 in the next few weeks.

  • If the S&P dips deep into Stage 3, big money interests may have some other agenda besides setting new all-time highs. Individuals would be best to re-evaluate their long positions on a dip deep into Stage 3, which currently exists between approximately S&P 2050 and 2100. A dip far below 2090, for example, would be far more than what would be necessary to take out stops, so such a dip should make the individual trader suspicious of the market’s bullish strength.
  • If the S&P merely goes to the brink of Stage 3 – falling not too far below the 2100 level on the S&P through early March – then individuals may want to consider whether big money was simply taking out stops on long positions before it engages in an attempt to push the S&P to new all-time highs. For example, a dip slightly below 2090, temporarily, would take out a lot of stops. However, an individual trader should be suspicious of such a dip being a trap designed to keep individuals out of a subsequent rally to new highs.
  • If the S&P remains in Stage 2 – remaining slightly above the 2090 level on the S&P through early March – then the individual trader cannot use this specific analysis to discern the motives of big money. In order for this analysis to provide valuable insight, the S&P must sink to the brink of Stage 3 (S&P~2090ish) and recover, or else sink deep into Stage 3 (well below S&P~2090ish). If it floats, buy it. If it sinks, abandon ship! If it never hits the iceberg, there’s no way to determine if it’s unsinkable.

Last week’s Thursday Evening Options Brief stated the following, which remains valid this week:

  • 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.

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 1980 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 1980 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 02-26-15

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 2100, Long Calls (and Married Puts) will retain profitability, suggesting the Bulls have retained confidence and strength. Levels above 2100 would suggest a continuation of recent sentiment, notably confidence by the Bulls. Below 2100, 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 the year 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 02-26-15

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 2159. Values above S&P 2159 could only occur during an irrationally exuberant Bull market. Values above 2159 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 2241 this week. Values above 2241 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. 2241 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 2037 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 2037 would likely bring a violent snap-back rally or else a violent resumption of the most recent downtrend. The 2037 level therefore divides an ordinary ‘pullback’ (above it) from a significant Bull-market ‘correction’ (below it). The 2037 level is currently on the ‘orange line’ of violence, historically one of the most un-sustainable and violent levels for the S&P.

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 02-26-15

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 -2.0%, 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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