Serious Consequences If SP 500 Tops 1900

by Chris Ebert, Zentrader

Stocks and Options at a Glance

Last week, as stock prices were undergoing a minor pullback, discussion here focused on the low probability of a major correction occurring during the remainder of 2013. That argument was based on the fact that the S&P 500 had once again entered Bull Market Stage 1, which is a market environment in which traders tend to buy the dips thereby decreasing the chances that a dip can evolve into an all-out correction.

This week, with the stock market again rallying, the focus is on how high the S&P can potentially go during the final weeks of 2013. Back on August 13, an analysis of several option trading strategies revealed that there was room for the S&P to climb to nearly 1900 by the end of the year, but that such a level represented the extreme upper limit. That analysis remains as valid now, at the end of November, as it was when it was first published. To read the original article click here.

Bull Market Stage 1 – the lottery fever stage – has its limits. Stock prices can only climb so fast before the frenzy of buying, no matter how much it is fueled by lottery fever, is outweighed by profit taking.

Click on chart to enlarge

*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 (NYSE:SPY)

You Are Here – Bull Market Stage 1

There are dozens of examples of Stage 1 exceeding its upper limit over the past 10 years, most recently in early May of 2013. Normally, what occurs after the limit is exceeded is that stock prices pull back slightly, sometimes bringing about a true Bull market correction, other times simply pulling back enough to bring the S&P back within normal limits.

The May 2013 event was followed by a decline of over points (intraday) in the S&P over the following weeks, and that is a typical response. A similar event occurred in March 2013 and was not followed by a significant pullback, but rather several weeks of choppy sideways movement that brought the S&P back within normal limits.

For now, the S&P is safely within the limits of Bull Market Stage 1. For the upcoming week, a rally to as high as 1859 would meet the upper limit of how high the S&P can go without risking excessive profit-taking. Anything above 1859, should it occur, should set off alarms for traders that the current rally is too much of a good thing.

• Covered Call (and Naked Put) trading is currently profitable, so it gets a grade of A+
• Long Call (and Married Put) trading is currently profitable, so it gets a grade of B+
• Long Straddle (and Strangle) trading is currently profitable, so it gets a grade of C+

A+ B+ C+ is indicative of Bull Market Stage 1 “Lottery Fever”. However at a level of the S&P above 1859 this week, Long Straddle trading profits would exceed 4%, a level that has historically been followed by consolidations, pullbacks, and corrections.

For a complete description of all Option Market Stages,click here.

What Happens Next?

As can be seen on the following chart, in order for the S&P reach 1900 by the end of 2013, it would have to again exceed its upper limit. Could a Santa rally push it to 1900? Maybe. But there would be almost certainly be consequences in early 2014 in the form of a choppy sideways market, a significant pullback, or possibly the first true Bull market correction since the summer of 2011.

It is possible that those with the most power in the stock market are not terribly concerned with any consequences that might occur in 2014, so long as they get what they want in 2013. If so, S&P 1900 is definitely on the table. But, if those same powers instead intend to keep the current rally going, correction-free, then the best way to do that (based on historical performance) is to keep the S&P from exceeding its upper limit.

As long as the S&P does not exceed the 1820-1860 range (represented by the green line on the above chart) between now and the end of the year, there is a good chance the current rally may continue, healthy and uninterrupted, into early 2014. However, if it does rally to near 1900 by year’s end, there is a good chance that the extra points might only be due to year-end window dressing, and the beginning of 2014 would have a good chance of being a disappointment.

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.

This past 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 1642 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.

Long Call trading has been profitable for most of 2013 except for a brief break from August through early October. The break in that historically long streak of profitability marked an important shift in bullish confidence; the Bulls lost the strength they had earlier in the year. This was evident in a failed attempt to break the 1710 weekly-close record on the S&P in September. The Bulls have since gained confidence, as revealed by the return of profits on Long Call trading, which has allowed the S&P to set new record highs in recent weeks. Only if the S&P closes the upcoming week below 1741 will Long Calls fail to profit, suggesting the Bulls have lost 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.

The LSSI currently stands at +0.3%, which is normal. Such levels suggest that option traders have had a good handle on predicting the future. Excessive profits, such as those exceeding 4%, will not occur this coming week unless the S&P exceeds 1859. Anything higher than that is likely to result in some selling pressure, and historically has been associated with Bull-market corrections. Excessive losses, such as those exceeding 6% will not occur this coming week unless the S&P falls to 1690. At or near that level a breakout is likely. 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.

Updates to the above analysis may be found at @optionscientist

Questions, comments and constructive criticism are always welcome. Enter them in the comment box below, or send them to [email protected]

The preceding is a post by Christopher Ebert, who uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. He studies options daily, trades options almost exclusively, and enjoys sharing his experiences. He recently co-published the book “Show Me Your Options!”