How Options Trades Characterize a Market

by Chris Ebert, Zentrader

There are a few important levels of the S&P 500 that every investor and trader should be aware of during the coming week. Even though these levels are derived from option trading, they are significant for stock performance

• Above 2005 – ridiculous and unsustainable
• Above 1933 – overbought, but sustainably so
• Above 1862 – very bullish, yet subdued, pending full digestion of recent gains
• Above 1826 – encountering strong resistance
• Below 1826 – in a correction
• Below 1719 – in a Bear market

As of May 10, the S&P currently stands at 1878, so if it remains a ir above its current level during the coming week, that would a very bullish sign. That’s because the market will shift gears this week, re-entering Bull Market Stage 2, if the S&P stays above 1862.

*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)

At or above that all-important benchmark – 1862 – option trades known as Long Calls* and Married Puts* will become profitable once again, after several weeks of losses. Profitability of those types of option trades only occurs in a very bullish market. Typically this happens when option premiums are low, causing implied volatility to be low as well (as measured by indicators such as the VIX). The low premiums, combined with a strong uptrend, result in profits for buyers of certain at-the-money Call options as well as those who buy Put options as protection for shares of stock When Long Calls or Married Puts are profitable, it is known here as Bull Market Stage 2, as can be seen on the chart below.

The S&P ended this past week in Bull Market Stage 3, which is known as the “resistance” stage, since it is often associated with strong brick-wall resistance that prevents stock prices from rising above a certain level. Such a level has existed for many weeks now, in the vicinity of 1880. Should the market shift into Stage 2 this coming week, which it could easily accomplish by doing nothing more than staying where it is, it is possible that the change in sentiment may provide the necessary ingredients for the S&P to finally break through the 1880 level and remain there for a while.

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 May 3, 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 -0.6%.
• Long Straddle trading is not currently profitable (C-). This week’s loss was -3.3%.

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, follow the link below:

Click here for complete descriptions of all individual Options Market Stages.

What’s next?

As noted above, anything above 1862 for the S&P this coming week would likely result in a shift in sentiment toward increasing bullishness associated with Bull Market Stage 2. So, as long as the S&P doesn’t fall significantly without recovering back above 1862 by the end of the week, the Bulls will gain strength and confidence, perhaps enough confidence to break through the brick wall near S&P 1880.

If, however, the S&P falls below 1862 this week and fails to recover by the end of the week, it would be a sign of weakness for the Bulls. Such weakness would be expected to maintain the brick wall near S&P 1880, perhaps making it more difficult to break through that level of strong resistance in future weeks or months.

On the above chart, the yellow line divides profit from loss on Long Call and Married Put option trades. Above the yellow line, which is at 1862 this coming week, the very bullish Stage 2 exists – as bullish as it gets, with the exception of Stage 1. Below the yellow line, a stalemate between Bulls and Bears exists in Stage 3, which is technically a bullish stage, but typically just doesn’t “feel” as bullish as Stage 2.

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 1719 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, Those losses intensified during April, and continued so far this May. 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 1862 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 1862, 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 -3.3%, which is low but not quite at the level of -6% considered excessive. Low levels, especially those below -6%, have historically been followed by major breakouts in which the S&P moves out of the trading range of the past several months. Breakouts can either occur as the S&P soars to new highs or else makes lower lows than it has experienced for quite some time.

Negative values for the LSSI represent losses for Long Straddle option trades. Losses, when excessive, represent one of three unusual conditions for Long Straddle trading, each with a distinct prognosis for the stock market.

Unusual Condition #1 – Profits on Long Straddle trades are unusual.
Profits on Long Straddle trades will not occur this coming week unless the S&P exceeds 1933. The S&P exceeding that level this upcoming week would indicate that Bull market of 2013 was once again underway and the recent correction/consolidation was simply a pause in the uptrend. Such profits, while unusual, are usually not a major concern unless they become excessive.

Unusual Condition #2 – Excessive profits on Long Straddle trades are very unusual.
Excessive profits on Long Straddle trades, such as those exceeding 4%, will not occur this coming week unless the S&P rises above 2005. Despite the presence of euphoria if the S&P was to reach that level, anything higher than 2005 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, major Bull-market corrections. In any case, 2005 is probably out of reach this coming week.

Unusual Condition #3 – Excessive losses on Long Straddle trades are just as unusual as excessive profits.
Excessive losses on Long Straddle trades, such as those exceeding 6% will not occur this coming week unless the S&P nears 1826. Excessive losses often occur when an extended stalemate between the Bull and the Bears has reached its limit and one side or the other is about to achieve a victory. Thus, at or near S&P 1820 this coming week a subsequent breakout is likely. Since the S&P is currently not terribly far from that 1826 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 1719, it could be a very, very bearish signal, while a bounce higher from the 1719 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.