By Chris Ebert

In the February 26 Thursday Evening Options Brief it was noted that:

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.”

This week’s analysis:

all clearThe S&P 500 has declined well off the all-time high recently achieved near the 2120 level. While the recent pullback off the high has not yet reached the 10% threshold (or 212 points off the high) to meet the traditional definition of a correction, it did indeed meet the definition of a correction offered by the options market.

As defined by option performance, a Bull-market “correction” would exist between a level of 2005 and 2057 for the S&P this week. That’s the range in which Covered Call* trading would exhibit some gains, but less than the maximum possible gains. Typically Covered Calls experience maximum gains during much of a Bull market, less-than-maximum gains occurring only during a correction, and losses occurring only during a Bear market.

Moreover, Long Straddles* tend to experience extreme losses during a correction, often approaching a level of 6%. This week, a level of 2005 to 2057 in the S&P is associated with extreme Long Straddle losses.

Welcome to Bull Market Stage 5

Thus, the dip into the upper 2030s on March 11 was enough to meet both options criteria for a correction:

  • Covered Calls still exhibited gains at that S&P level, but the gains were below the maximum amount possible for such trades.
  • Long Straddles suffered losses approaching 6%.

A dip below 2005 before bouncing higher would have been considered beyond the scope of a normal correction, instead signaling a potential Bear market. Covered Call losses would have occurred below S&P 2005 this week, not the small gains normally associated with Bull-market corrections. Additionally, Long Straddle losses would not have been anywhere near the 6% threshold had the S&P declined that far.

A dip that did not fall below 2057 would not have met the minimum requirement to be considered a correction. Not only would Covered Calls have returned their maximum profit, but Long Straddle losses would have been well below 6%; neither of the criteria for a correction would have been met. Only a dip to the narrow range between 2005 and 2057 meets the options definition of a correction, and that’s exactly what occurred.

Now that the S&P has bounced higher, the correction can likely be considered complete, at least for a little while. The S&P 500 has now entered a zone known as the “all clear”, or Bull Market Stage 5. This stage can sometimes bring the most explosive growth in stock prices of any environment. The following analysis provides details as to why such growth can occur.

 Stocks and Options at a Glance 03-14-15b

* 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 5 – the “All Clear” stage.

On the chart above there are 3 categories of option trades: A, B and C. For this week, as of March 12, 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 +2.5%.
  • Long Call and Married Put trading are each currently not profitable (B-).
    This week’s loss was -2.8%.
  • Long Straddle and Strangle trading is currently not profitable (C-).
    This week’s loss was -5.6%.

The combination A+ B- C- occurs whenever the stock market is at Bull Market Stage 5, the “All Clear” stage, which gets its name from the tendency of stock prices to have found a major level of support and then bounced higher off of that support.

Options Market Stages

Click on chart to enlarge

The level at which stock prices bounce is very important. Too low, and the bounce can be considered a temporary dead-cat bounce; too high and the level of support can be meaningless. A bounce that occurs after a Bull-market correction (no more, no less) is the sweet spot that leads to the sounding of the all-clear signal.

The chart at right shows the general market environment for Bull Market Stage 5 in comparison to all of the 11 different 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.

Recent Bounce was Perfect

Stock prices always bounce higher after a sell-off, eventually, even if it’s just a dead-cat bounce. The level at which they first bounce is what determines the health of the overall market. Since the S&P bounced after reaching into correction territory, the current Bull market can still be considered intact. Had the S&P waited to bounce until it fell below 2005 this week, the Bull market would be much more questionable. The S&P is only as strong as its most recent bounce.

  • A bounce that occurs during Bull Market Stage 3 often leads to a brick wall of resistance at recent highs
  • A bounce that occurs during Bull Market Stage 4 often wipes clean all major levels of resistance
  • A bounce that occurs during Bear Market Stage 5 tends to be a temporary dead-cat bounce

Since the most recent bounce (the one that occurred March 12) occurred during Stage 4, it is quite possible that most major former levels of resistance in the S&P 500 have now been erased. That makes it entirely possible that the S&P could zoom to all-time highs without hitting a brick wall when it reaches the old highs.

 OMS 03-14-15b

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

The reason all-time highs are more likely to occur now, after reaching Stage 4 than they would have been after a bounce from Stage 3 is that the level of support achieved during Stage 4 is generally much stronger. Taking the market to the brink of bearishness, without a Bear market actually taking hold, is a show of strength for Bulls. The market didn’t just recover from sickness; it picked up its deathbed and carried the bed away. That’s a sign of life.

In Stage 3 the market isn’t truly sick. Maybe a case of the sniffles, sure, but it isn’t sick enough to be on its deathbed. Thus, picking up the bed and walking away with it is not considered a miracle during Stage 3. By the same token, a recovery that only occurs after Bear Market Stage 5 has been reached is usually too little, too late. A recovery that occurs during Bear Market Stage 5 is more like a patient being moved into hospice care to provide comfort, not a cure.

Readers here may recall that the market experienced a historically rare recovery from Bear Market Stage 5 back in October 2014. Nothing is ever a sure thing when it comes to the stock market. Certainly it is possible for the current bounce off of support in Stage 4 to fail, and the market could turn bearish – anything’s possible. But, for now it would appear that the S&P 500 has been given the all-clear signal of Bull Market Stage 5. If this rally holds without sinking back into Stage 4, new all-time highs could occur very quickly.

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 2008 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 2080 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 03-12-15

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 2127, Long Calls (and Married Puts) will retain profitability, suggesting the Bulls have retained confidence and strength. Levels above 2127 would suggest a continuation of recent sentiment, notably confidence by the Bulls. Below 2127, weakness and a lack of confidence should be abundantly apparent.

Long Call trading losses returned several weeks ago, after returning profits for the majority of the year 2014, a major sign of a recent lack of bullish confidence and strength. A return to profits after a period of absence would be a huge boost of confidence for bullish traders.

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 03-12-15

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 2186. Values above S&P 2186 could only occur during an irrationally exuberant Bull market. Values above 2186 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 2269 this week. Values above 2269 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. 2269 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 2062 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 2062 would likely bring a violent snap-back rally or else a violent resumption of the most recent downtrend. The 2062 level therefore divides an ordinary ‘pullback’ (above it) from a significant Bull-market ‘correction’ (below it). The 2062 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 03-12-15

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 -5.4%, which is abnormally low and nearing -6.0% which is typically a level of concern. It is indicative of a market that has 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)

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 likely to occur on its own accord, even if not prompted by a sufficient news catalyst, because the LSSI is abnormal. 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, Chief Options Strategist at Astrology Traders (which offers subscribers unique stock-trading perspectives and options education) and co-author of the popular option trading book Show Me Your Options! Chris 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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Thursday Evening Options Brief 26 Feb-15

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