by Chris Ebert, Zentrader
“Fool me once, shame on you; fool me twice, shame on me“. It is remarkable how much insight that one simple phrase can provide for the stock market.
Nobody likes to play the fool, especially the financial fool. Unfortunately just about everyone will be a financial fool at some point; it’s nearly unavoidable, no matter how much effort is exerted. But the motivation to avoid making the same mistake twice is one of the strongest motivators of human behavior.
There’s little shame in being fooled by the stock market once. Avoiding the shame of being fooled twice – that’s what drives the stock market.
But what is it about the stock market, exactly, that tends to make someone feel like a fool? Obviously, a sudden severe sell-off such as the Crash of 1929, or Black Monday of 1987, can bring on feelings of foolishness for stock owners. Anyone who held stocks through the Financial Crisis of 2008 likely felt like a fool for a time as well.
Foolishness itself has a quantum characteristic. That is to say, the feeling does not tend to vary in intensity; it is either present or it is not. Once it’s present, it can be very persistent, lasting long beyond the event that initiated it. So, it can be helpful to identify it early, in ourselves as well as other participants in the stock market. An analysis of some simple stock options may be helpful in that regard.
* All profits are calculated at expiration, as a percentage of the underlying SPY share price. SPY is an ETF that closely tracks the performance of the S&P 500, specifically the SPDR S&P 500 ETF Trust (NYSEARCA:SPY). All options are ATM-when-opened 4 months (112 days) to expiration. (e.g. Profit of $6 per share on a Long Call would represent a 3% profit if $SPY was trading at $200, even if the call premium itself actually increased 50%, 100% or more)
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 August 2, 2014, this is how the trades performed:
- Covered Call and Naked Put trading are each currently profitable (A+).
This week’s profit was +2.9%. - Long Call and Married Put trading are each currently profitable (B+).
This week’s profit was +0.6%. - Long Straddle and Strangle trading is currently not profitable (C-).
This week’s loss was -2.3%.
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. This stage gets its name from the tendency for stocks to experience periods of gains interspersed with relatively minor pullbacks, each temporary pullback being the market’s way of digesting the prior gain.
A chart describing all of the different Options Market Stages is available by clicking the link to the left to enlarge.
New Record High S&P Not Entirely Impossible
Readers here have been reminded recently that changes in the nature of the Bull market were not just possible, but probable, should stock prices decline. However, not every decline in stock prices causes a change in sentiment. If a decline in stock prices causes a major shift in the profitability of certain stock options, then that is when the shift often occurs.
A roaring Bull market can suddenly turn volatile and bearish, as if making a quantum leap. Once the leap has been made, the Bull market is over, at least temporarily, no matter how much it recovers or how healthy it may appear in the short term. Once the damage has been done – once traders have been made to feel sufficiently foolish once – the effect will eventually become evident, sometimes almost immediately, sometimes many days or weeks later.
The effect comes from traders’ doing their best to avoid the shame of becoming a fool twice, not necessarily a knee-jerk reaction to having been made a fool once. Even when the foolishness does not put a complete end to a Bull market, it often puts up a brick wall that temporarily blocks any meaningful progress to higher stock prices. The effect – in this case, the presence of a brick wall of resistance – can be misleading, since the effect generally lags the cause – the cause being the avoidance of shame. A dead-cat bounce is a classic example of the effect lagging the cause; an Elliott “B” wave is another.
Some recent articles regarding a shift in sentiment include:
While those articles focus on identifying changes among traders as a group, it can be helpful to also consider the reasons for those changes, and, specifically, the reason those changes are not always immediately noticeable.
Shame on You, Stock Market!
The two most common ways the stock market can make a trader feel foolish are:
- for stock prices to fall, causing a shareholder to either suffer a large loss or give back large gains, or
- for stock prices to rise while a trader is sitting on the sidelines, causing either the missing of huge gains or missing of the opportunity to recoup previous losses.
The stock market fools just about everyone at some time, though not everybody at the same time. In a Bull market, traders tend to get fooled by temporary declines in stock prices during a broader uptrend. But, after being fooled into missing the uptrend, many eventually learn to accept the dips, even embrace them as a buying opportunity.
Those who get fooled twice (selling their shares on a temporary decline in a long-term uptrend) are more likely to drop out of the market out of shame. Better to miss out on possible gains and settle for lower fixed returns in other types of investments than to endure the shamefulness of being a financial fool yet again, at least that’s the rationalization.
Essentially, one must bear the shame and admit to having been fooled twice in order to return to the stock market when it is making highs after having left the market when it was making lows. While it is O.K. to blame the stock market for getting pushed out at the lows “Shame on you, stock market!” a trader who returns after the lows have passed must accept the shame of having missed some gains “Shame on me!”
For many traders the shame can be too much to bear, thus they may never return to the stock market, in effect permanently casting shame on the market for being such a difficult, risky, perhaps rigged environment. As long as a trader does not return to the market, no matter how large the loss suffered or the amount of gains that may be missed, the blame is not on the trader, but the market, and the shame as well. Again, that’s the rationale, not necessarily the reality.
After a sharp downturn in an otherwise bullish market, it is understandable that some traders may not return, at least not for a long time afterward. The downturn can affect other traders differently.
Fool Me Twice?
After a sharp sell-off in stocks and a decline in prices:
- Some traders leave the stock market never to return, either to avoid being fooled again or out of necessity, due to a loss of account value
- Some traders are scared away, perhaps sold out automatically through a stop-loss, thus may find it difficult to return right away, even if the market rallies, due to the shame of being fooled by the dip, or fooled into placing too narrow a stop.
- Some traders get scared, but having been fooled in the past by temporary dips, vow to get out on the next rip rather than sell stocks at their lows again, which would be like being fooled twice.
- Some traders likely don’t notice the dip, especially those who do not manage their own accounts closely, but likely realize after the fact, after the dip has passed, that they could have lost a great deal, thus enticing them to sell to avoid the shame of leaving themselves so vulnerable in the future.
The amount of a dip in stock prices that causes the above actions can be estimated by a number of methods. Simple moving averages (sma’s) are a common tool for this purpose. While a dip to a 50-day or 100-day sma commonly fools traders into selling too early, those who are not fooled tend to hold on even stronger once the dip has passed. A dip below the 200-day sma, though, is often like flipping a switch, making everyone feel foolish simultaneously.
Fibonacci methods also offer some assistance in defining the level of a dip that makes traders weary of being fooled. A dip to the 61.8% level, for example, can make traders feel smart for holding stocks or even adding to positions, but a dip below that level can make the same traders suddenly feel foolish.
Elliott waves can help identify feelings of foolishness. The first wave down, referred to as the “A” wave often makes stockholders feel foolish while a simple dip in the uptrend of wave “5” tends to make those who got out on the dip feel foolish.
Each method, whether it involves moving averages, Fibonacci or Elliott analysis has advantages and disadvantages. No method is perfect. Thus, traders may want to consider an analysis of the options market, if for nothing else than a second opinion.
Despite a dip that violates an important sma or Fibonacci level or the suspected appearance of Elliott Wave A, traders sometimes don’t feel collectively foolish until stock prices dip so far that Long Calls stop profiting. The presence of Long Call losses also acts like a light switch, or more accurately, Long Call losses coincide with the flipping of an emotional switch, causing panic to set in. Feelings of foolishness can induce panic. The panic effect is discussed at length, here: Don’t Panic until Call Options Fail
Since not all traders react the same way to panic, its effect can be delayed. But once the switch has been flipped, there is usually no way of changing the eventual outcome. Stock prices will very often meet a brick wall of resistance as panicked traders bail out of their stocks when they return to their previous highs. At least, the ones who were “smart” enough not to bail out at the lows will do so.
Those who were “foolish” and bailed at the lows certainly won’t feel comfortable getting back in at the highs. Not only did the stock market fool these poor folks once on the dip, it fooled them again on the rip. Their collective shame can be observed, as their absence from the market causes a decrease in momentum when stocks re-visit their highs. Normally, their presence would help sustain momentum. But, shame changes them. The change is discussed here: “Buy the Dip” is now “Sell the Rip”
Long Call losses occur in the yellow zone in the chart, shown here as Bull Market Stage 3 – the “resistance” stage. The nice thing about Long Calls is that their profitability depends on the premium of the options, which is derived from trader’s expectations of the stock market. A Long Call during a period of low implied-volatility, for example when the VIX is 15 will generally cost much less to open than during elevated volatility, such as when the VIX is 30.
Lower premiums make it more likely that a Long Call will profit when the VIX is low, thus dips are less likely to cause a loss, mirroring traders’ willingness to ignore dips when the VIX is low, as often occurs during a mature Bull market. Higher premiums when the VIX is elevated make it more likely for Long Calls to suffer losses on dips, mirroring traders’ propensity to feel foolish and take action to avoid being fooled twice, quite commonly by selling their stocks.
Whereas a simple moving average can be effective, it can lose its effectiveness when the market shifts gears. For example, a 200-day sma depends in part on stock prices from 200 days earlier; and those 200-day old prices may no longer have much significance when the sma is calculated.
The same ineffectiveness can plague Fibonacci analyses at times, since, for example, a 61.8% level may be derived in part from stock prices many months, even years earlier, which may no longer have as much influence if something fundamental has shifted the market in the meantime. While Elliott waves generally react quickly to such shifts if the time frame of the wave is chosen carefully, the waves can be difficult to interpret at times. Long Call option performance is not perfect either, but there is a good historical accuracy at pinpointing future brick walls when Long Call losses occur. Plus, Long Calls are just plain simple.
Long Calls depend on both the stock price and the future expectations for the stock price. The added bit of information – trader’s expectation – can make the result more valuable than a simple sma. Additionally, Long Calls require less input from the analyzer. For example, as long as a Long Call has an at-the-money (ATM) strike price the expiration date does not have as large an influence on the result as, say, the choice of moving average.
A Long Call that expires in 50 days or 100 days usually yields similar results. Not so for a 50-day or 100-day sma, where results are quite different in most circumstances other than moving average crossovers. With Fibonacci the analyst must choose the level of importance, for example 61.8%, 50%, 30.9% etc. With ATM Long Calls, a loss is a loss. With Elliott waves the analyst must choose the time frame, for example to decide whether wave A in one time frame is more important than wave 5 in another. For an analysis of ATM Long Calls, the analyst’s choice is not nearly as important.
When Long Call losses occur, expectations have not been met, and traders tend to feel foolish. Even if some traders do not bail out of their stock positions immediately, once they feel foolish they need to feel smart again, usually by bailing out at the next opportunity. That creates resistance, like a brick wall, at least temporarily, sometimes more than temporarily.
Long Call losses on the S&P 500 have not yet occurred in the most recent dip. That does not mean a brick wall of resistance does not exist at the recent highs in the 1980s range; it may exist for other reasons. It just means that such a brick wall is not as likely as it would have been if Bull Market Stage 3 had taken hold – if Long Calls stopped returning profits – if stock owners, collectively, suddenly felt like fools.
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, which balances sluggish responses of longer expirations with irrelevant noisy responses of shorter expirations.
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, nearly 3 full years later, in 2014.
As long as the S&P remains above 1806 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 1806 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.
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 which balances sluggish responses of longer expirations with irrelevant noisy responses of shorter expirations.
Long Call trading became unprofitable this past March, Those losses intensified during April and early May before reverting back to profits in recent weeks and months. 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 1921, Long Calls (and Married Puts) will remain profitable, suggesting the Bulls retain confidence and strength. Below 1921, 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, which balances sluggish responses of longer expirations with irrelevant noisy responses of shorter expirations.
The LSSI currently stands at -1.5%, 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 1979. Values above S&P 1979 would suggest a return to the recent 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 2053 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 1867 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 1867 would be a major bullish “buy the dip” signal, while a break below 1867 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]