by Chris Ebert, Zentrader
Stocks and Options at a Glance
Buy the dip! It can be a puzzling strategy for stock traders and investors. Buying the dip requires buying stocks when prices have fallen. The goal is to scoop up shares of stock at bargain prices when they have reached the bottom of the dip – the dip being a temporary break in a longer-term uptrend – thereby profiting when prices resume their climb.
There is a problem with buying the dip; it is impossible to know for sure whether the dip is actually a temporary event or the beginning of a larger downtrend in stock prices. If a trader buys the dip, and prices subsequently fall even further, the result will be a loss.
Although it is impossible to know with 100% certainty when it is safe to buy the dip, as a general rule it is safe in a Bull market. So, all a buy-the-dip trader really needs to know is whether or not it is currently a Bull market. Sometimes it is easy to tell. For example, with major stock indices such as the Dow and the S&P setting record highs recently there is no question that this is a Bull market. In fact, the current market is known here as Bull Market Stage 1 – the “lottery fever” stage.
Determining when a Bull market is over is not so simple. Although there are numerous definitions of a Bull market, the Options Market Stages are particularly effective at drawing the line between Bull and Bear. Buy-the-dip traders may therefore benefit from an analysis of the Stages, which are published here weekly.
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*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 1
Lottery fever is often one of the best Market Stages for a buy-the-dip trader because dips never last very long. For the upcoming week (ending August 10), lottery fever will continue as long as the S&P 500 remains above 1658.
The stock market never makes guarantees, but as long as the S&P remains above 1658 this week, long straddle option trading will remain profitable; and long straddle profits define the “lottery fever” stage. The implication is that there would be a high expectation that buying the dip will be a profitable strategy, at least in the short term, as long as the S&P stays above 1658 through August 10, based on historical performance.
Where Do We Go from Here?
The following represents the dividing line between Long Straddle trading profits and losses, and thus the line dividing “lottery fever” from less-bullish market stages. If the S&P 500 index remains at or above these levels, expectations for buy-the-dip trading should be very high.
Above these weekly S&P levels, buy-the-dip expectations are high:
- Aug 10 – 1658
- Aug 17 – 1678
- Aug 24 – 1705
- Aug 31 – 1724
- Sept 07 – 1757
Lottery fever is not the only stage of a Bull market. Buying dips can be profitable in other types of Bull markets as well, for example a Bull Market Correction. However, there is a trade-off; buying the dip during a Correction carries a higher potential reward if prices rebound, but there is a higher risk of such a dip evolving into a Bear market.
In the options market, it can be considered a Bull market as long as Covered Call trading does not result in losses. It may be helpful for a buy-the-dip trader to know the point at which Covered Call trading would become unprofitable, since that would be a strong indication of the presence of a Bear market. Bear markets are generally not conducive to buy-the-dip trading.
The following represents the dividing line between Covered Call trading profits and losses, and thus the line that likely separates a Bull market from a Bear market in the S&P 500 index. If the S&P falls below any of these levels, expectations for buy-the-dip trading are low.
Below these weekly S&P levels, buy-the-dip expectations are low:
- Aug 10 – 1504
- Aug 17 – 1535
- Aug 24 – 1568
- Aug 31 – 1588
- Sept 07 – 1620
One way to think about these levels is to consider the reason why buy-the-dip trading would tend to be ineffective below them. Strange as it may seem, the reason is that fewer traders are willing to buy the dip. When prices fall in a Bear market and there are fewer traders willing to buy the dip, who is going to buy all of the stocks that sellers are anxious to sell?
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Click Here for a complete chart of all Options Market Stages
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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.
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This week, Covered Call trading and Naked Put trading were both profitable, as they have been for an extended period. In fact, Covered Call trading became profitable in late 2011 and has remained profitable every week since then except for two very minor losses. That means the Bulls have been in control since late 2011 and remain in control today. As long as the S&P remains above 1504 over the upcoming week, the Bulls will retain control of the longer-term trend. 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.
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This week, Long Call trading and Married Put trading were both profitable, as they have been since February 1, 2013. That is a historically long streak of profitability, and an indication that the Bulls are stronger and more confident now than they have been at any time in the past 10 years. It will take something really big to upset their apple cart now. As long as the S&P closes the upcoming week above 1606, the Bulls will retain confidence and strength. 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.
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The LSSI currently stands at 2.3%, which is high but not abnormally so. It does indicate that the Bulls have overstepped their authority a bit, but that is to be expected occasionally when the market is rallying. Sometimes traders start taking their profits off the table when the LSSI gets above zero in a Bull market, and the result can be a temporary pullback or correction. Other times stock prices continue higher and this pushes the LSSI above 4.0%, which makes a correction even more likely, as even more traders are likely to walk away with their profits.
A level of the S&P above 1719 this coming week would push the LSSI over 4% signaling that the market was “Due for a Correction”. An elevated LSSI has always led to a correction in the past, and there’s no reason to suspect the next occurrence will be an exception. It’s just a matter of how long until it occurs. 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.
