by Chris Ebert, Zentrader
There is one thing readers will notice is commonly absent from this series of weekly analyses of the stock market and the options market – the news.
Trading without regard to the news can seem strange and perhaps foolish to those who have never attempted it. Nevertheless, it is possible to successfully participate in the stock market while ignoring much of the news and instead relying on some form or forms of technical analysis to signal the best times to buy, to sell or to sit on the sidelines.
While many traders may be looking to the news for clues about where the stock market may be headed next, the truth is that stock market is often so disconnected from the economy that the news cannot cause changes in the stock market that would not have occurred anyway. In other words:
Bad news does not ordinarily cause stock prices to fall; stock prices fall when the pattern of stock prices becomes conducive to falling prices, which may or may not coincide with bad news.
It is true that news can control an individual stock, or a small number of related stocks, as is perhaps most commonly evident when companies release earnings reports; and it can even affect the broader market temporarily. But, as for the stock market in general, as represented by large baskets of stocks such as the Dow, S&P 500 and Nasdaq, the effect of the news is usually minor compared to the effect of trader sentiment.
*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)
Trader sentiment causes the stock market, as a whole, to either perform well or perform poorly. It is convenient, when good economic news happens in the vicinity of a stock market that is performing well, or bad news when it is performing poorly, to assume that the news is responsible for the changes. However, the correlation of the news with subsequent changes in stock prices does not necessarily imply that there is also causation. It is quite plausible that the news may simply act as a catalyst to stimulate traders to act upon emotions that were already present. The catalyst (the news) cannot create a reaction unless the proper ingredients (the proper patterns of stock prices) are present. Taken to the extreme, it has been said that not even a major declaration of war – a seemingly Bearish news event – can, on its own, end a Bull market.
Trader sentiment tends to vary somewhat predictably, as shown in the following analysis. This past week shows that traders are currently taking a break, and digesting the gains of the rally of recent weeks. That the break happened to coincide with unsettling developments in Iraq is likely almost purely coincidental. The market was ready for a break, and it took one, as often happens when the S&P 500 enters what is known here as Bull Market Stage 2 – the “digesting gains” stage.
You are here – Bull Market Stage 2 – the “digesting gains” Stage.
On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending June 14, 2014, this is how the trades performed:
- Covered Call trading is currently profitable (A+). This week’s profit was +3.2%.
- Long Call trading is currently profitable (B+). This week’s profit was +2.0%.
- Long Straddle trading is currently not profitable (C+). This week’s loss was -1.2%.
Using the chart above, it can be seen that the combination, A+ B+ C-, occurs whenever the stock market environment is at Bull Market Stage 2, known here as the “digesting gains” stage. It is so named because it often encompasses a period of consolidation (digestion) which follows a significant rally and often precedes the next leg up for stock prices in general.
For a description of Stage 2, as well as a comparison to all of the other stages, see the chart on the left (click to enlarge):
What Happens Next?
In many past occurrences of Bull Market Stages 2, stock prices have simply taken a break for a week or two, sometimes several weeks, and then re-tested a recent high, often surpassing that high with very little in the way of resistance.
If such a scenario was to occur now, the S&P would have a good chance of re-testing the recent all-time high near 1950, while the Dow would likely go along for the ride, also setting a new record. There is really no reason to doubt this scenario, at least not yet.
What would throw a wrench into the next leg up would be if the level of 1950 was to become a brick wall of resistance. Some may recall the brick wall that developed at the 1880 level earlier this year. The 1880 brick wall, as with all brick walls, including a possible future 1950 brick wall, have one thing in common – they all tend to develop after the stock market enters Bull Market Stage 3 – the “resistance” stage.
The S&P has not yet entered Stage 3, so it is unlikely that there is a brick wall being built at the 1950 level currently. But, if the S&P falls below 1917 this week and stays there through Friday’s close, there is a much better chance that a brick wall will go up, since that would coincide with the beginning of Bull Market Stage 3.
The transition to Stage 3 is not arbitrary. It follows an easily observable event – being a change to a market in which once-profitable Long Call option trades are no longer profitable. Simply stated, historically there has been a high correlation between Long Call losses and subsequent brick walls of resistance developing at recent highs; hence the name “resistance” given to Stage 3.
If the S&P does not dip below 1917 this week, traders should be prepared for the next leg up in this Bull market that has been going strong and without correction since late in the year of 2011. If it does dip below 1917, traders should be prepared to encounter a brick wall if the S&P later nears 1950 again.
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 1802 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. Below S&P 1802 this week, Covered Calls and Naked Puts will not be profitable, and since such trades only produce losses in a Bear market, it would suggest the Bears were in control.
he 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 early May before reverting back to profits in recent weeks. 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.
As long as the S&P closes the upcoming week above 1917, Long Calls (and Married Puts) will remain profitable, suggesting the Bulls retain confidence and strength. Below 1917, Long Calls and Married Puts will not be profitable, which would suggest a significant shift in sentiment, notably a loss of confidence by the Bulls. Confidence and strength show up as a “buy the dip” mentality, while a lack of confidence and strength produces a “sell the rip” sentiment that tends to set recent highs as brick-wall resistance, since each test of that high is perceived as a rip to be sold.
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 -1.2%, which is normal, and indicative of a market that is neither in imminent need of correction nor in need of a major breakout from the trading range of the last few months. Positive values for the LSSI represent profits for Long Straddle option trades. Profits represent an unusual condition for Long Straddle trading, one of three unusual conditions that warrant attention.
The 3 unusual conditions for a Long Straddle or Long Strangle trade are:
- Any profit
- Excessive profit (>4% per 4 months)
- Excessive loss (>6% per 4 months)
Long Straddle trading (and Long Strangle trading) will not be profitable during the upcoming week unless the S&P closes above 1974. Above S&P 1974 would suggest a significant shift in sentiment, back to a euphoric “lottery fever” type of mentality that tends to lead to a rally for stock prices.
Excessive Long Straddle trading profits (more than 4%) will not occur unless the S&P exceeds 2048 this week, which would suggest absurdity, or out-of-control “lottery fever” and widespread acceptance that stock prices have risen too far too fast for the rate to be sustainable, thus needing to correct in order to return to sustainability.
Excessive Long Straddle losses (more than 6%) will not occur unless the S&P falls to 1862 this week. Since excessive losses tend to coincide with a desire for traders to make stock prices break out, either higher or lower than the boundaries of their recent range, a break higher from 1862 would be a major bullish “buy the dip” signal, while a break below 1862 would signal a full-fledged Bull market correction was underway.
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]