by Chris Ebert, Zentrader
Last week, readers here were alerted to the possibility that if the S&P 500 did not experience a pullback, it was likely to rally. Thus, the expectation was for either 2000 or bust for the S&P over the next few weeks.
The reasoning has not changed this week – the S&P continues to act very bullishly. In fact, stock prices have increased so quickly that they are nearly at a point where they could soon affect the performance of some simple option trades, and if so, those option trades would then indicate a stock market that is as bullish as it gets.
The option trades worth watching over the next week or so are Straddles and Strangles.
- When either of those strategies is applied to the S&P as a whole, any resulting profit is an indication of widespread extreme bullishness.
- Extreme bullishness tends to induce euphoria among traders.
- Such euphoria tends to have similarities to the “lottery fever” that often surrounds large lottery jackpots.
- A market in which Straddles and Strangles on the S&P are profitable is known here as Bull Market Stage 1 – the “lottery fever” stage.
While the S&P has not quite climbed high enough to reach Stage 1, another 25 points or so is all it would take to make the transition. The stock market continued to experience the mild bullishness of Stage 2 – the “digesting gains” stage this past week, but anything above 1902 over the upcoming week would likely unleash extreme bullishness of lottery fever of Bull Market Stage 1.
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 2.7%.
- Long Call trading is currently profitable (B+). This week’s profit was 2.1%.
- Long Straddle trading is not currently profitable (C-). This week’s loss was 0.5%.
The combination, A+ B+ C-, occurs whenever the stock market environment is currently at Stage 2. In order for the market to switch to Stage 1, category C trades – Straddles and Strangles – must become profitable once again. Since profitability is shown with a “+” sign, the switch to Stage 1 would result in a C+ for Long Straddle Trading. The combination of A+B+C+ occurs whenever the stock market is under the influence of Stage 1 lottery fever, and can be seen on the chart above. The implications of lottery fever may be seen on the chart below.
What Happens Next?
When the euphoria of Bull Market Stage 1 takes over the market, the S&P tends to climb as high as it can go until it hits resistance. There is always the chance that something unforeseen could derail the S&P (war, disaster, etc.), so there is never a guarantee that the S&P will soar during lottery fever. But, the general trend under the influence of euphoria is usually towards the highest stock prices that the market can tolerate.
Many times, there are tangible levels of resistance for the S&P, and it is therefore expected that stock prices will stop rising, at least temporarily, when the S&P has reached one of those levels. Such levels often exist at old high prices, or places at which the S&P has experienced strong support or strong resistance in the past. However, with the S&P now at all-time highs, no such levels exist.
The S&P cannot experience resistance at an old high, because the S&P has never been this high before. The market is in uncharted territory now, or, to look at it another way, the S&P is operating without any clearly defined levels of resistance.
There are ways to calculate logical levels that might present resistance for the S&P in the future, perhaps most notably through the use of Fibonacci calculations. For those who are not Fibonacci experts, stock options can provide a quick and easy estimate of the next level of strong resistance of the S&P.
It turns out that, historically, a level of the S&P which would return a profit in excess of 4% in 4 months on an at-the-money Straddle* is often a level of strong resistance. For the upcoming week, a level of 1974 on the S&P would produce a profit of 4%. Over the next several weeks, that level varies within 20 points or so of 2000, as can be seen as the green line on the chart. Thus if the S&P does manage to soar as a result of lottery fever in the next few weeks, strong resistance could be expected in the neighborhood of S&P 2000 (plus or minus about 20 points).
For a complete description of all of the Options Market Stages, click here
- If the S&P exceeds 1902 this coming 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 1853 this coming 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 1902 nor falls below 1853, 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.
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 1756 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 1853, 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 -0.5%, which is within normal limits. Profits on Long Straddle trades will not occur this week unless the S&P exceeds 1902. Anything higher than 1902 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 1974. Despite the presence of euphoria if the S&P was to reach that level, anything higher than 1974 this coming week is absurd and is likely to result in some selling pressure. Historically, such absurd bullishness 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 1794. 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 1756, 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]