Caution For Long Stocks When Long Calls Fail

by Chris Ebert, Zentrader

With the U.S. markets currently in a long holiday weekend, many traders are likely enjoying a break from market analysis. So here is something to consider that will only take a few moments, but may prove to be an immense help during the week ahead.

A type of option trading, known as Long Call* trading, is usually profitable whenever a strong Bull market is underway. Conversely, whenever a strong Bull market is underway, Long Call trading is profitable.

Although the S&P soared 2.5% higher this past week, a holiday-shortened week no less, Long Call trading remained unprofitable. Thus, this is not a strong Bull market, at least not from the perspective of a Long Call trader.

A weak Bull market can strengthen – that is always a possibility – so it would not be beyond comprehension if stocks continued to rally during the coming week. But, at the same time, traders should be prepared in case the already weak Bull market weakens further.

“Buying stocks when Long Calls fail to profit is tantamount to fighting the tides of the sea.”

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)

When Bull markets become weak, pullbacks can be both swift and severe, and they can occur with or without accompanying economic news. If a significant sell-off does indeed occur in the next few weeks, readers here may want to consider that the reason for such a sell-off may be nothing more than weakness, as evident in the S&P’s failure to climb any higher than Bull Market Stage 3 this past week.

You are here – Bull Market Stage 3.

On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending April 12, 2014, this is how the trades performed:

• Covered Call trading is currently profitable (A+). This week’s profit was +2.7%.
• Long Call trading is currently not profitable (B-). This week’s loss was -1.5%.
• Long Straddle trading is not currently profitable (C-). This week’s loss was -4.2%.

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. For a description of Stage 3, as well as a comparison to all of the other stages, the following chart is provided:

Click on chart to enlarge

What’s next?

As can be seen on the chart above, the stock market tends to progress through a Bull market in a “textbook” manner – beginning at Stage 0, then 1, 2, 3 and 4, before bouncing higher at Stage 5 and then repeating the process all over again beginning at Stage 0.

The market, however, occasionally is not as well behaved as a textbook example. Occasionally Stage 4 is followed by a reversion to Stage 3 instead.

While Bull Market Stage 5 is often an “all clear” signal that the S&P 500 has bottomed out and has completed a “correction”, a reversion to Stage 3 offers far less confidence that such a bottom has occurred. While by no means mandatory, a market that reverts to Stage 3 prior to reaching a major support level may be setting itself up for a test of support in the near future.

Quite simply – if a Bull-market correction brings the S&P down to the very line that divides Bull from Bear – the red line in the chart above – then a bounce higher sends a strong signal to all traders that the Bulls have defended their territory and won, and it is a time for celebration. The battle was fought and won, which may increase traders’ confidence, in turn leading to higher stock prices and resumption of the Bull market trend.

On the other hand, if buyers step in to “buy the dip” before the S&P reaches the dividing line between Bull and Bear, nobody can say for sure whether the Bulls would have won that battle. The battle was never fought, so traders may lack confidence as they may be unsure whether strong support exists, or will exist, if the S&P was to approach the red line. The market may rally; but any sell-offs, should they occur, could be exacerbated by the lack of confidence.

Whether last week’s bounce for the S&P pushed the market ahead into Bull Market Stage 5, or back to Bull Market Stage 3, is open to debate. We will know soon enough which one is correct. Stage 5 is highly-bullish, buoyed by strong support below. Stage 3, though bullish, is weighed down by brick-wall resistance from above. Therefore, Stage 5 is likely to quickly lead to new weekly highs above the current brick-wall resistance level in the 1880s; while Stage 3, at best, is likely to slam into that brick wall, and at worst could easily evolve into a Bull-market correction that tests for support in the 1790s over the upcoming week or so.

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 1776 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 became unprofitable this past March, and those losses intensified during April. Losses for Long Calls are a sign of weakness for a Bull market. Such weakness can be dangerous because it lowers the perceived reward potential for stock owners, which makes stocks less attractive, in turn lowering the price stock sellers are able to obtain from buyers.

Failure of the S&P to close next week above 1887 would be a sign of continued weakness; and weakness always has the potential of putting downward pressure on stock prices. If the S&P fails to close the upcoming week above 1887, 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 -4.2%, which is very near the level of 6% normally considered excessive. Such levels have historically been followed by major breakouts in which the S&P moves out of the trading range of the past several months, and either soars to new highs or else makes lower lows than it has experienced for quite some time.

Profits on Long Straddle trades will not occur this coming week unless the S&P exceeds 1942. While nothing in the stock market is impossible, reaching 1942 this coming week is highly unlikely. The S&P exceeding that level this upcoming week would indicate that Bull market of 2013 was once again underway and the recent correction 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 2016. Despite the presence of euphoria if the S&P was to reach that level, anything higher than 2016 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, 2016 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 nears 1832. At or near 1832 a subsequent breakout is likely. Since the S&P is currently not terribly far from that 1832 level, the chances of a major breakout are elevated now. As mentioned in Step 1, if a breakout brings about a lower trading range, especially below 1776, it could be a very, very bearish signal, while a bounce higher from the 1776 area would be a strong indicator that the market had put in a bottom, at least temporarily, 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.