by Chris Ebert, Zentrader
Here is a way to analyze the current stock market environment in about 10 minutes or less using just a few simple steps. The following analysis, now in its third year, is presented each weekend in order to give traders an edge in their trading by improving the ability to recognize the current market environment and speed the reaction to any changes in that environment.
This week: step by step instructions for a market analysis using stock options.
Where is the stock market today?
*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)
The first step in any form of stock-market analysis is to define the current environment for stocks. We want to know not just if a Bull market or a Bear market is currently underway, but how bullish or how bearish.
We do not need to actually trade stock options to glean insight from those options. Here, we will study the performance of just three of the simplest, most basic types of options; and those options will tell us a great deal about the current stock market environment.
The three option trades are:
- Covered Calls
- Long Calls
- Long Straddles
Now, we want these options trades to represent the stock market as a whole, not just an individual stock or a single sector of the economy; so we must use options that represent a basket of stocks. Indices such as the Dow, Nasdaq, and S&P 500 contain enough of a variety of stocks to give us a good idea of the general market. Here, we will use options on the SPDR S&P 500 ETF Trust, widely known by its ticker symbol “SPY”, which encompasses a wide variety of stocks in the S&P 500 index.
Not just any options on SPY will due. We don’t want the options to react too quickly to changes in the market that may not agree with the overall trend. This means we will avoid options that expire in a week or a month, as their analysis tends to produce too much noise. We will also avoid those that expire in a year or more, as they tend to not react quickly enough to produce reliable signals when the market environment changes. For our purposes, options that expire in 4 months (112 days) will suit us well.
One more thing: we can’t just use any old strike price for the options. We need something standard – something that will not change from week to week. For this we will use an at-the-money strike price, since it is always the same as the underlying share price.
What we will have, for each of the trades listed above, is an option on SPY opened 4 months prior to expiration using a strike price that was at-the-money at the time the trade was opened.
For this past week, ending March 29, 2014, this is how the trades performed:
- Covered Call trading is currently profitable (A+). This week’s profit was 3.0%.
- Long Call trading is not currently profitable (B-). This week’s loss was -0.2%.
- Long Straddle trading is not currently profitable (C-). This week’s loss was -3.2%.
Using the chart above, we can see that the combination, A+ B- C-, occurs whenever the stock market environment is currently at Bull Market Stage 3.
What does the current Market Stage indicate?
Now that we know where the stock market is today, we can compare it to similar conditions that have existed in the past. For example, during this past week, ending March 29, 2014, the market entered Bull Market Stage 3. The following chart depicts the conditions the generally occur at each different market stage. Consulting the chart gives us historical conditions that have typically accompanied Stage 3.
As can be seen on both of the above charts, the stock market tends to progress through the market stages in a particular order. That is – Bull markets tend to progress from Stage 0 through Stage 5, and then repeat those same stages over and over again, beginning at Bull Market Stage 0 and ending at Bull Market Stage 5.
Eventually, all Bull markets come to an end, and it is at that point where Bull Market Stage 5 fails to occur, and is instead replaced by Bear Market Stage 5. A Bear market tends to progress from Bear Market Stage 5 through Bear Market Stage 9, at which point it ends and a new Bull market begins at Bull Market Stage 0.
The progression of the market through the above stages does not always occur in textbook fashion. For that reason, we may find it quite helpful to look at the actual progression of the current stock market, as measured by the S&P 500, through the Options Market Stages, as it has occurred over the past weeks and months.
What is the current trend in the Options Market Stages?
With the same three option trades as above, we can use the combination of the outcome of those three trades to determine the upper and lower limits of each stage using a little bit of algebra.
For example, we can determine the level of the S&P that would result in neither a gain nor loss for a Long Call trade – in other words, a 0% profit. If we perform this calculation weekly, we can then plot the resulting values on a graph. Since a 0% profit from Long Call trading is the dividing line between Long Call profits and Long Call losses, the resulting line on the graph will divide Bull Market Stage 2 from Bull Market Stage 3 (see previous chart to confirm that the only difference between Stages 2 and 3 is the profitability, or lack thereof, of Long Call trading).
Following the above procedure, we can calculate dividing lines for all of the Options Market Stages and then plot them all on a graph, such as the one below. Superimposing the actual performance of the S&P 500 on top of the Options Market Stages gives us a visual representation of how the S&P has progressed recently as compared to how it would be expected to progress in a textbook example.
Where might the market go next?
While the intent of this analysis is to provide traders with a current view of the stock market environment, there are some aspects of the analysis that lend themselves to forward-looking assessments. That is to say – the Options Market Stages can offer some insight into the future of the stock market. The reason for this ability is that we are plotting the profit or loss of the option trades at expiration. For example, we can calculate with absolute accuracy, the level of the S&P at the June expiration, 4 months in the future, that would result in a profit for a Covered Call opened now, in the month of March, 4 months prior to expiration. We are not predicting where the S&P will be in 4 months, because nobody knows for sure. Nevertheless, the data provided allows us to gain insight into the future.
Perhaps most obvious among these insights is the ability to predict the maximum level that the S&P is likely to reach in the next few months. For example, the S&P is not likely to go much above 2000, even under the most bullish market conditions, until at least mid-May. To exceed 2000 would cause Long Straddle trades to exceed 4% profits, something that Long Straddle trades rarely do. On the chart, the green line represents 4% profits on Long Straddle trades.
The next most obvious insight is that level of the S&P that would be indicative of a Bear market, from an option trader’s perspective, will vary greatly over the next several months. While it would take a dip to near 1700 in the S&P to currently signal a Bear market, that level at times moves to 1800 through June. To be considered bearish, Covered Call trading must experience losses. On the chart, the red line divides profits from losses, and thus bullishness from bearishness, respectively, should the S&P be above or below that line.
Perhaps not immediately obvious from the chart, is that future performance of the S&P sometimes tends to correlate with the current Options Market Stage. For example, the S&P often meets with brick-wall resistance if it rallies after entering Stage 3. That’s exactly how Bull Market Stage 3 got the nickname “the resistance stage”. Since the S&P did indeed enter Stage 3 recently, there is a good chance it will encounter strong resistance if it manages to rally back toward the neighborhood of 1880.
While studying the above charts, many of us are likely to notice what may appear to be a glaring error – that Bull Market Stages 0 through 5 are identical to Bear Market Stages 0 through 5. But, it’s not a mistake. The beginning of a Bear market is no different than a Bull market. That’s why so many traders are taken by surprise by a Bear market. The differentiation between Bull and Bear generally only occurs at Stage 5, when the failure to bounce higher off of support results in a loss of support, causing sidelined and short traders to be reluctant to buy stocks at the same time stock owners are motivated to sell – the very definition of bearishness, while a bounce causes the opposite, stock owners reluctant to sell while sidelined and short traders are motivated to buy.
The above analysis is relatively simple, even though it attempts to employ some complex forms of analysis. There are influences from, among others, Elliott wave analysis, Relative Strength Index (RSI), moving averages and related crossovers (MACD) and Bollinger Bands. Yet, the whole analysis takes only a few minutes, even less if we just look at the charts.
It is often helpful to see the analysis from a different frame of reference. We may therefore benefit by breaking up the analysis into its separate parts, and then analyzing those individual parts. 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 1714 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 and thus far in 2014 except for a brief break from August through early October, The return to losses this March marks a shift in sentiment among traders, This is no longer the roaring Bull market that it was a few weeks ago. It is now a market that has lost momentum, so much so that buying Call options is not currently a profitable strategy. If the S&P fails to close the upcoming week above 1837, 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 -3.2%, which is within normal limits. Profits on Long Straddle trades will not occur this coming week unless the S&P exceeds 1898. Anything higher than 1898 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. While 1898 is not out of the question this coming week, such a level would represent remarkable gains for the week.
Excessive profits on Long Straddle trades, such as those exceeding 4%, will not occur this coming week unless the S&P rises above 1969. Despite the presence of euphoria if the S&P was to reach that level, anything higher than 1969 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. In any case, 1969 is almost certainly out of reach this coming week.
Excessive losses on Long Straddle trades, such as those exceeding 6% will not occur this coming week unless the S&P falls to 1792. 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 1714, it could be a very, very bearish signal, while a bounce from that level would be a strong indicator that the market had put in a bottom at a level of strong support.
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.