by Chris Ebert, Zentrader
Stocks and Options at a Glance
With just one look, it is now possible to see exactly which option strategies are currently profitable and which are not. Those who use option performance as a technical indicator can now see where the stock market is today (as measured by the S&P 500 index) and where it is likely to go next, with a simple “You Are Here” marker.
Click to enlarge
You Are Here – Bull Market Stage 1
Stocks are now in Stage 1 of a mature bull market. Bull markets tend to progress from stage 0 to stage 5 and then repeat the process, beginning again at stage 0. Stage 1 represents an over-extended market, which often precedes a correction. The correction often occurs within a week or two, but Stage 1 has historically lasted as long as 4 months. The current Stage 1 began on March 9th.
Click to enlarge
There are currently no signs that the market is moving from Stage 1 into Stage 2, and the change sometimes happens without warning. Moreover, there is no time limit on any stage, so it is possible for the market to stay at one stage for several months, or to pass through several stages in a matter of weeks or days. In the case of a black swan event or a market crash, the market has at times passed through several stages within hours.
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.
Click to enlarge
This week, covered call trading and naked put trading were both profitable, as they have been for an extended period. That means the Bulls remain in control. 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.
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.
Click to enlarge
This week, long call trading and married put trading were both profitable. Both forms of trading became profitable in late January. It means the Bulls are not only in control now, but they are confident and strong. 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, but they are 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.
Click to enlarge
On March 9th, long straddle trading and long strangle trading reached rare and absurd levels of profitability. Such levels normally precede a correction. That does not preclude a possible move higher prior to the correction though. Although rare, the market can, and historically has added gains for as long as 4 months or so, even after the LSSI has indicated that the market is “Due for a Correction.”
On May 11th, the LSSI again exceeded the +4% limit that normally precedes a correction. While no technical indicator is correct 100% of the time, over the past 10 years a correction of at least 5% to 10% in the S&P has always ensued within 4 months or so after the LSSI initially topped 4%.
Here in May 2013, we are now more than two months past that initial date when the LSSI topped 4%, which would suggest that we have very little chance of getting to July without a correction.
The correction will occur, eventually. An elevated LSSI has always led to a correction in the past, and there’s no reason to suspect this time 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.
*Option position returns are extrapolated from historical data deemed reliable, but 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.
