For March It Is New Highs or Bust

by Chris Ebert, Zentrader

A funny thing about the S&P 500 is that it sometimes hits a brick wall when approaching a major resistance level, and other times plows right on through.

The most recent example of the S&P plowing through resistance occurred this past week. After setting an all-time high near 1850 back in mid-January, stocks experienced a significant pullback. Often times, such a pullback will essentially set such an all-time high in stone, so that a subsequent rally will have difficulty surpassing the previous all-time high – like hitting a brick wall.

Readers here were alerted to the possibility of the S&P encountering no such brick wall this time around. Here’s what was discussed back on February 9:

At the current stage, Stage 2, the market has only pulled back slightly, despite media portrayals of an apocalypse. As long as the S&P falls no lower than the bottom of Stage 2 (above the yellow line on the chart), there is a good argument that the S&P could soar past its recent highs of 1840 – 1850 with little or no resistance.

Little or no resistance – that’s exactly what happened as the S&P approached its old high near 1850 this past week.

• Monday, traders tried and failed.

• Tuesday and Wednesday, they tried again.

• Thursday, they succeeded and the S&P closed at 1854!

• Friday, they confirmed their success, and the S&P closed at 1859.

Three days of trying was all it took for traders to push the S&P above the 1850 level – a level which had the potential to act like a brick wall. Historically, though, brick wall development requires the market to first enter Stage 3 – the “resistance” stage. Since the market remained at Stage 2 in recent weeks, and did not dip to the level of Stage 3, brick-wall resistance was much less likely.

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 (NYSEARCA:SPY)

You Are Here – Bull Market Stage 2

Recognizing whether the stock market is currently at Stage 2 requires a quick analysis of the three categories (A, B, and C) of option strategies shown in the chart above, using a plus (+) for profitable strategies and a minus (-) for unprofitable ones.

• Covered Call trading is currently profitable (A+). This week’s profit was 2.8%.

• Long Call trading is currently profitable (B+). This week’s profit was 2.2%.

• Long Straddle trading is not currently profitable (C-). This week’s loss was 0.7%.

The combination, A+ B+ C-, occurs whenever the stock market environment is at Stage 2. Stage 2 normally represents a market that is digesting recent gains. Digestion tends to occur as stock prices move up and down within a range, but make no real progress in either direction. This is to be expected, as some traders are focused on selling stocks they bought several weeks ago at all time highs and held through the recent dip in prices because they can now get out of those stocks without a loss, while others are focused on buying stocks at a bargain prior to what they expect may be the next leg up into higher prices.

So, that’s where we are this week – at a point where the S&P has pretty much digested all of the gains of this past December and early January. Everyone who bought stocks at the January highs has now had plenty of time to unload those stocks at a profit, or at least at break-even; and everyone who was waiting for the S&P to breakout to new highs, as a signal to go long, has now had several days to load up on stocks.

What Happens Next?

Ordinarily, Stage 2 is a temporary stage that tends to last a few weeks at most. Either the market digests its recent gains and then resumes the uptrend, often by reverting back to Stage 1 – the “lottery fever” stage, or it does not.

For a complete description of all of the Options Market Stages, click here

The S&P came very close to reverting back to Stage 1 this past week, but it did not; and that could be an ominous sign; here’s why. The continuation of Stage 2 this week is an indication that the market is continuing to digest recent gains. That contradicts the fact that the S&P broke through the 1850 resistance level and held above that level, which would suggest that all gains have been digested.

So, which is it? Is the market still digesting gains, or is it finished? As always, this analysis is not so much concerned about predicting the future as it is with allowing traders to recognize important future events before they become clear to others, thereby giving traders a potential edge. For this coming week, it is important to be able to recognize whether Stage 1 lottery fever has returned to the stock market, or whether Stage 3 has snuck in, bringing with it a much more subdued outlook for the weeks ahead.

• If the S&P exceeds 1895 this week, Stage 1 will return, likely bringing lottery fever back to the market, which usually shows up as euphoric buying among traders. This could easily lead to a rally toward 2000 over the upcoming weeks. On the above chart, Stage 1 is above the blue line.

• If the S&P falls below 1846 this week, Stage 3 will begin, which is often associated with the development of a brick wall of resistance near recent highs. If resistance becomes a brick wall, it would take some super-terrific economic news to give stocks enough momentum to break through that wall. On the above chart, Stage 3 is below the yellow line.

• If the S&P neither exceeds 1895 nor falls below 1846, Stage 2 will continue. But, Stage 2 represents digestion, and digestion seldom lasts as long as it has. This digestion phase is getting mighty stale, and the market is likely to make a decision soon as to whether Stage 2 will end with a reversion to Stage 1 or by beginning a new Stage 3.

When looking at the above three choices for the near future of the S&P, it is interesting to note that the recent breakout above 1850 occurred with very little resistance. It took just 3 days for traders to push through that level, certainly not what one might expect from a brick wall.

While a breakout above resistance can sometimes morph into a subsequent level of support, the strength of that support can depend on the how strong the resistance was. Brick-wall resistance can lead to brick-wall support, or, as in the current state of the market, weak resistance at S&P 1850 might lead to future weak support at 1850; and that’s fine, as long as future economic developments do not put too much stress on whatever support there is.

For a more in-depth examination of the Options Market Stages, the following 3-Step analysis is provided.

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.

Covered Call trading did not experience a single loss in 2013, and the streak endures so far in 2014, continuing a streak of nearly lossless trading extending all the way back to late 2011. That means the Bulls have been in control since late 2011 and remain in control here in 2014. As long as the S&P remains above 1750 over the upcoming week, Covered Call trading (and Naked Put trading) will remain profitable, indicating that the Bulls 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 was profitable for almost all of 2013 except for a brief break from August through early October, and remains profitable today. However, Long Calls are now near the dividing line between profits and losses. A return to losses would mark a significant shift in sentiment among traders, and would be a harbinger of weakening of the current Bull market. If the S&P closes the upcoming week below 1846, Long Calls (and Married Puts) will 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 -0.7%, which is within normal limits. Profits on Long Straddle trades will not occur this week unless the S&P exceeds 1895. Anything higher than 1895 indicates the presence of euphoria, often accompanied by lottery-fever-type bullishness, so the S&P exceeding that level this upcoming week would indicate that Bull market of 2013 was once again underway and the pullback in January and early February was simply a pause in the uptrend.

Excessive profits on Long Straddle trades, such as those exceeding 4%, will not occur this coming week unless the S&P rises above 1967. Despite the presence of euphoria if the S&P was to reach that level, anything higher than 1967 is likely to result in some selling pressure, and historically has been associated with subsequent pullbacks and, occasionally, Bull-market corrections.

Excessive losses on Long Straddle trades, such as those exceeding 6% will not occur this coming week unless the S&P falls to 1787. At or near that level a subsequent breakout is likely. That level is important to watch, as anything below it, should it occur, is likely to indicate a major Bull-market correction is underway, and the market is likely to break out into a lower trading range. As mentioned in Step 1, if such a lower trading range was to fall below 1750, it could be a very, very bearish signal.

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 [email protected]