Brick-Wall Resistance May Develop Soon

by Chris Ebert, Zentrader

For the past several weeks, the same theme has been repeated here. That theme – that March would be a month in which the S&P either soared towards 2000 or else puttered out – has not changed.

What has changed this week is that S&P suddenly sunk into Stage 3. It’s technically still a Bull market, but instead of a Bull market without much clearly-defined resistance, the 1880 level now has a greater likelihood of acting like a brick wall.

One of the major catalysts that pushed the S&P into Stage 3 was uncertainty and unrest in Ukraine. Should that unrest disappear, the S&P may again begin to soar. While the S&P might continue on its previous path toward 2000, it’s now much more likely that it will encounter strong resistance, at least temporarily, if it rises toward 1880. An in-depth analysis follows.

*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 3

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 not currently profitable (B-). This week’s loss was 0.7%.
• Long Straddle trading is not currently profitable (C-). This week’s loss was 3.4%.

The combination, A+ B- C-, occurs whenever the stock market environment is currently at Stage 3

Stage 3 is a market environment in which at-the-money Long Calls and Married Puts on the S&P are no longer profitable when opened 4 months prior to expiration. It takes a fairly strong Bull market to make such trades profitable – strong, like the one that dominated much of 2013.

With Long Calls and Married Puts currently being unprofitable types of option trades, there is an indication that the Bull market is not as strong as it was just a few weeks ago.

What Happens Next?

This past week’s transition from Stage 2 to Stage 3 marks a significant blow to the current Bull market. The change is not as severe as a Bull-market correction, but it is nonetheless significant.

Stage 3 is known here as the “resistance” stage because it tends to mark a slowing of momentum for rising stock prices, so much so that recent high prices may tend to become brick-wall resistance in the future. Resistance at recent highs develops as traders become less and less confident that stock prices will ever exceed those highs.

Once Stage 3 is underway, traders who bought stock at recent high prices, now feeling pressure to get out of those stocks if they ever return to break-even, tend to create selling pressure if stocks do return to those same highs. Such pressure does not normally accompany more-bullish stages, such as Stage 1 or 2, since traders at those stages are accustomed to stocks routinely making new highs after each dip. The “buy the dip” mentality becomes much less common when Stage 3 begins.

When analyzing the market as a whole, the recent high of the S&P near 1880 is much more likely to become a brick wall if that level is approached over the upcoming weeks.

So, what we have now is a market in which the S&P may stall if it approaches 1880 again. That is much different for a trader, in terms of risk vs. reward, than a market which, until recently, appeared to have the S&P headed towards 2000 without any obstacles.

Stage 3 has occurred many times in the past 10 years, and can be seen on the chart of the LCMPI that follows. Each instance in which the LCMPI dips below zero marks the beginning of a new Stage 3; and each Stage 3 tends to be followed by at least several weeks during which the S&P has difficulty reaching new highs. The presence of Stage 3 correlates with resistance in the future.

Some recent examples of Stage 3 are May-August 2012, November 2012 – January 2013, and August – September 2013. The effects of the earlier examples may be seen on the chart of the LCMPI. The effect of the most recent Stage 3 may be seen on the chart above, as the S&P struggled to push through the 1700 level this past September. The effect of not reaching Stage 3 may also be seen on the chart above, as the S&P encountered very little resistance at the 1850 level this past February. The absence of Stage 3 correlates with minimal resistance in the future.

For the week ahead, here is what to watch for:

• STAGE 1: If the S&P exceeds 1915 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.
• STAGE 2: If the S&P exceeds 1860 this coming week, but remains below 1915, Stage 2 will return. While Stage 2 is bullish, it is not nearly as bullish as Stage 1. So, although the trend in stock prices is generally to the upside, wild swings in stock prices sometimes occur as the bulls and bears fight it out. On the above chart, Stage 2 is above the yellow line.
• STAGE 3: If the S&P remains below 1860 this coming week, Stage 3 will continue, which is often associated with the strengthening of brick-wall resistance near recent highs. If resistance at the recent high near 1880 becomes a brick wall, it would take some super-terrific economic news to give stocks enough momentum to break out above 1860 over the next several weeks. On the above chart, Stage 3 is below the yellow line.
• STAGE 4: If the S&P falls below 1806 this coming week, Stage 4 will begin. This stage normally represents a major correction in a Bull market. Such corrections tend to seek out the dividing line between a Bull market and a Bear market. On the above chart, Stage 4 is below the orange line, and the dividing line between a Bull market and a Bear market is the red line.
• STAGE 5: If the S&P falls below 1751 this coming week, Stage 5 would begin, marking the beginning of a Bear market that may last a few months to a year or more. On the above chart, Stage 5 is below the red line.

The following chart provides a complete description of the Options Market Stages.

Click on chart to enlarge

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 1751 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 remained profitable in 2014, until now. The return to losses this past week marks a significant shift in sentiment among traders, and could be a harbinger of weakening of the current Bull market. If the S&P fails to close the upcoming week above 1860, 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 -3.4%, which is within normal limits. Profits on Long Straddle trades will not occur this coming week unless the S&P exceeds 1915. Anything higher than 1915 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 recent pullback 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 1987. Despite the presence of euphoria if the S&P was to reach that level, anything higher than 1987 this coming week would be absurd and would 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 1806. 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 would be at risk of breaking out into a lower trading range. As mentioned in Step 1, if such a lower trading range was to fall below 1751, 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]