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I’m a swing trader of momentum stocks with a holding period of anywhere from a few hours to a few months. I run a number of screens to locate the strongest/weakest stocks out there, using technical analysis to determine my entries and exits. Trying to calculate the intrinsic value of stocks in... More
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  • Minimum Requirement For A Bear Market

    By Chris Ebert

    The best time to prepare for a Bear market, as with any foreseeable disaster, is long before it strikes. If one waits for word of a Bear market to be broadcast on the evening news, chances are good that it is already too late to prepare.

    It's too late to build a storm cellar when the tornado sirens are blaring, too late to get off the volcano when the pyroclastic flows have begun, and too late to buy bread and milk when the blizzard winds are howling. The best one can normally hope for, when a disaster is already underway, is to mitigate the damage; and that includes stock market crashes.

    The problem with preparing for disaster is that there is a natural tendency to become desensitized to warnings that later prove inaccurate. As television's Simpsons character Troy McClure observed many years ago, in 1995, "phony tornado alarms reduce readiness". So to do phony predictions of coming stock market crashes reduce readiness.

    Many have viewed the widely circulated charts showing the similarities of the current stock market to that of the Crash of 1929. While it is conceivable that such similarities could indeed mean we are headed for another stock market crash, the truth is that so many similar predictions have failed in the past that even if this one proves to be true it will likely be ignored, quite like phony tornado alarms.

    As with any indicator, including stock market indicators, the value of the indicator depends on its ability to avoid as many false alarms as possible, while retaining the ability to send all valid alarms with enough advance notice to allow for time to prepare. Too many issued false alarms, too many missed valid alarms, or too many valid alarms issued too late, make any indicator useless.

    With those constraints in mind, here is a nearly foolproof means of analyzing stock options in order to warn of a Bear market affecting the stocks in the S&P 500 while there is still time to prepare.

    (click to enlarge)

    * All profits are calculated at expiration, as a percentage of the underlying SPY share price. SPY is an Exchange Traded Fund (NYSEMKT:ETF), the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) that closely tracks the performance of the S&P 500 stock index. All options are at-the-money (ATM) when-opened 4 months (112 days) to expiration. (e.g. Profit of $6 per share on an expiring Long Call would represent a 3% profit if $SPY was trading at $200, regardless of whether the call premium itself actually increased 50%, 100% or more)

    You are here - Bull Market Stage 1 - the "Digesting Gains" Stage.

    (click to enlarge)Click on chart to enlarge

    On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending September 20, 2014, this is how the trades performed on the S&P 500 index ($SPY):

    • Covered Call and Naked Put trading are each currently profitable (A+).
      This week's profit was +2.5%.
    • Long Call and Married Put trading are each currently profitable (B+).
      This week's profit was +2.0%.
    • Long Straddle and Strangle trading is currently not profitable (C-).
      This week's loss was -0.5%.

    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 significant pullbacks, as if traders are taking time to digest each individual gain. Digestion is often bullish, but not nearly as bullish as the recent lottery fever of Stage 1 which occurred in late August and early September.

    A chart describing all of the different Options Market Stages is available by clicking the link at the left.

    What is a Bear market?

    In order to sound the alarm signaling the presence of a Bear market, the first step is to define exactly what a Bear market is. Such a task may seem simple enough, but it is not.

    Take a typical definition of a Bear market being a 20% decline in stock prices. If every 20% decline in stock prices represented a Bear market, there would be no need to analyze the market further; a trader could become wealthy simply by buying stocks and holding them, only to dump them the moment a 20% decline came about.

    The problem with rigid numerical definitions (e.g. a 20% decline) is that such rigidity does not allow for sufficient flexibility to avoid false alarms of a Bear market while simultaneously capturing every true Bear market with enough advance notice to allow for preparations (e.g. selling stocks).

    Perhaps a better method of defining a Bear market is to simply state that it is a stock market in which the risk of owning stock is greater than the perceived reward.

    The risk is tangible, and easily calculated; the reward is not. Stock prices can only fall to zero, at worst, so the risk of stock ownership is always known. The reward, on the other hand, is not known. Since stock prices have no upper limit, the potential reward of stock ownership cannot be defined, thus the potential reward is nothing more than the perception among traders of how high the stock price will go.

    When stock prices are going up, the consensus among traders is generally that there is a reward. Traders may disagree on the amount of the potential reward, nevertheless they usually agree that there is a potential to profit from a continuation of the upward trend in prices.

    If stock prices climb too far, too fast, the consensus can quickly shift. A perception that stock prices have reached a limit and have little potential upside can lead to a sell-off. Quite simply, the risk of loss (that stocks could go to zero) outweighs the perception of reward (that there is little chance of upside profits), stock prices can tumble until either the risk decreases, or the perceived reward increases, or both. When stock prices fall to a point at which an equilibrium is reached - when weighted risk equals the perceived reward - that's when prices stop falling and begin to rise once more.

    Sometimes, however, prices do not reach equilibrium, at least not for many weeks or months. In a cascading effect, falling stock prices sometimes do not represent bargains,

    • In a Bull market - Falling prices cause an increase in the perception of the potential rewards of stock ownership, and a simultaneous decrease in risk.
      Falling prices leave more perceived room for upside moves, thus the further stock prices fall the greater the perceived reward. As stock prices decrease in a Bull market, maximum risk decreases (since stock prices are getting closer to zero - zero being their lowest possible value) while perceived reward increases, thus equilibrium is reached relatively quickly as the two forces are moving towards each other.
    • In a Bear Market - Falling stock prices cause a decrease the perception of the potential rewards of stock ownership, and a simultaneous decrease in risk.
      Falling prices are perceived as likely to be followed by even more falling prices, thus the further stock prices fall, the lower the perceived reward. As stock prices decrease during a Bear market, maximum risk decreases (since stock prices are getting closer to zero - zero being their lowest possible value) but the perception of potential reward is decreasing as well. Equilibrium takes much longer to reach in a Bear market because the forces, risk and reward, are traveling in the same direction, not toward each other as in a Bull market.

    In the most extreme example possible, if stock prices were to fall to zero in a Bear market there would be no risk in stock ownership but there would be a perception of a potential reward. Therefore, individual stock prices rarely go all the way to zero, even when a the company that issued the stock has gone bankrupt, as long as a glimmer of hope remains, no matter how faint.

    Stock indexes, such as the Dow Jones, Nasdaq or S&P 500 are even less likely to go to zero than the individual stocks they contain, for the simple reason that the closer the index gets to zero, the lower the risk. Thus, the tiniest glimmer of hope for potential reward can outweigh the risk of going to zero, especially as the index gets closer to zero. Equilibrium, even in the most severe of Bear markets, will be reached long before a major stock market index reaches zero.

    Importance of Option Traders in Bear Markets

    The reward for an option trader is often quite different than the reward for a stock owner. Option traders can and do earn profits when stock prices fall. The fact that it's possible for some option traders to profit from a Bear market, however, is an oft overlooked useful bit of information that can be used to identify a Bear market.

    If chosen carefully, the profitability of certain options can serve as an early-warning Bear-market alarm for all traders, stock market traders included. Unlike the profitability of short-selling stocks, which occurs whenever stock prices fall regardless of whether the price decline constitutes a Bear market, certain specific options only profit during a Bear market.

    Since every option contract has a buyer and a seller, the profit of every option owner is always equal to the loss of the seller and vice versa. The options market is truly a zero-sum game. Options neither create nor destroy wealth, but merely move wealth from one place to another. That's a stark contrast to the stock market, in which wealth can be created as well as destroyed.

    It is important to note the inability of options to have any net effect on total wealth, because any analysis of options that only includes positions that experience an increase in wealth must exclude all positions that experience a decrease. The profits and losses of individual option positions are meaningless unless the net positions are known. Individual options themselves are therefore often poor indicators of the stock market, however, combinations of options and stock positions often provide very meaningful data.

    For example, a trader may buy 100 shares of stock and sell 1 standard Call option. The stock price may subsequently rise above the strike price of the option and the Call option owner may exercise the option. In this case the Call buyer may experience a profit, since exercising the Call option allows him to buy 100 shares of stock at the strike price of the option and then sell those 100 shares of stock at a higher price on the open market.

    The Call seller may also experience a profit, as long as the purchase price of the stock was less than the net sales price, when accounting for the Call option premium received. Both the Covered Call seller and the buyer of that particular Call option can each make a profit at the same time, on the same stock.

    In order to use options to determine whether a Bear market is underway, it is necessary to study only those options which would give stock owners a perceived reward that is greater than the risk of loss. This narrows down the list of potentially hundreds of possible combinations that would serve as a Bear market indicator, to just two:

    • A stock owner can buy Put options (Protective Puts) to limit risk
    • A stock owner can sell Call options (Covered Calls) to generate a reward

    The presence of a Bear market, as outlined earlier, is evident whenever the risk of owning a stock is greater than the perceived reward potential. Also as previously outlined, not every decrease in stock prices results in a Bear market. Only those decreases in stock price that cause the risk of stock ownership to be greater than the perceived reward are bearish; declines that do not tip the risk/reward scale can often be healthy Bull market corrections.

    A stock owner always has risk. The only way to eliminate risk completely is to sell the stock; and the only reason to eliminate risk completely is because of a perception that the potential reward is not worth the risk. As long as risk can be limited to a reasonable level by buying Put options, there is no immediate need to sell stocks that are owned.

    Stock owners who buy Protective Puts can and do experience losses, but as long as Puts are cheap, the risk is relatively small. In a Bull market, when implied volatility is low, as is commonly indicated when the VIX is low (below 20), Puts are relatively inexpensive. It is unlikely if not impossible for a Bear market to begin while Put options are cheap - when the VIX is low.

    No matter how deep a sell-off, no matter how severe a correction, as long as stock owners can limit risk with inexpensive Puts, the perceived reward of stock ownership will always be greater than the risk. A Bear market simply cannot take hold until the VIX is elevated, until Put premiums become so high that the risk of protecting stocks with Puts outweighs any potential perceived reward.

    Even when option premiums rise, there is an alternative to stock owners. Rather than buy Puts for protection, they can sell Covered Calls against their existing stock positions. The higher the implied volatility (the higher the VIX) the higher the Call premiums; so the reward of stock ownership remains intact even during a decline in stock prices, thanks to the options market.

    The only way the risk of stock ownership can become so great that it exceeds the perceived reward potential is for a stock owner to run out of suitable option alternatives. The stock owner can buy Protective Puts, and if that doesn't offer enough reward for the risk, sell Covered Calls. If Covered Calls don't offer enough reward for the risk, then there are very few suitable alternatives.

    How much reward for the risk is acceptable? That's certainly debatable. However, when there is zero reward for the risk, there is not really much left for debate. When a stock owner cannot limit risk to an acceptable level with at-the-money (ATM) Put options, or can't create any reward at all selling at-the-money (ATM) Covered Call options, it's time to sell the stock.

    Sure, it's possible the stock owner could use in-the-money (NYSEARCA:ITM) options and might be able to eke out a profit. But is it worth it? Buying ITM Protective Puts or selling ITM Covered Calls is a little like chasing a bus, and the profits, if there are any, are often not worth the effort, much less the risk of loss. That doesn't mean all ITM options are bad choices; but when ITM options are the only ones a stock owner can use successfully, it might be better for a stock owner to just sell the stock and sit on the sidelines for a while.

    Historical Success Identifying Bear Markets

    The following chart shows the profitability of several common types of option strategies applied to the S&P 500 index as a whole. Above the yellow line, in the blue and green zones, stock owners who protect their positions by buying ATM Put options earn a profit. There's no way a Bear market can begin if stock owners can buy Put options and still earn a profit; it's simply not possible.

    (click to enlarge)

    An expanded 10-year historical chart is now available.

    Below the yellow line, in the yellow zone, stock owners may experience a loss if they protect their positions with Puts, however, stock owners who did not buy Puts can still earn a profit. Not every stock owner buys Puts for protection; some choose to trade without a safety net. Those traders will profit from rising stock prices, even when the increase is very small, since they are not spending anything on option premiums for protection. A Bear market is highly unlikely to begin when stock prices are still rising.

    Below the orange line, in the orange zone, stock owners may experience losses, but not if they sold ATM Covered Calls against their existing stock positions. It is highly unlikely a Bear market could begin when stock prices fall, as long as it is possible for stock owners to continue to profit from their stocks, by selling Call options.

    Below the red line, in the red zone, stock owners cannot experience a gain by buying ATM Put options or by selling ATM Covered Calls against their existing positions. Below the red line, the stock owner has run out of options... literally. The red line therefore defines the point, at any time, past or present, at which the risk of stock ownership outweighs the perceived reward.

    A Bear market is almost a certainty below the red line, and almost certainly impossible above it. For historical perspective, the following chart shows the level of the S&P 500 relative to the red line. In other words, this chart shows how for the S&P would need to fall for a Bear market to begin (if a Bull market is underway) or how far the S&P would need to rise for a Bear market to end (if a Bear market is underway).

    The chart below is formed by viewing the S&P 500 from the vantage point of the red line as depicted on the chart above. For the week ending September 20, 2014, the most recent date for which data was available, the red line in the chart above is located at the 1903 level for the S&P 500, so on the chart below the S&P is approximately 5.3% higher than the red line, at the 2010 level. 2010 (the current S&P level) = 1903 (the current red line level) + 5.3%.

    (click to enlarge)

    For example, if the S&P 500 is 5% above a Bear market, a level of 2000 for the S&P would indicate that a decline of more than 5%, or 100 points, would likely cause a Bear market. A decline of 5% or less, 100 points or less, would be considered a Bull market correction. This gives traders an opportunity to place stop-loss orders in order to avoid losses caused by a Bear market.

    The chart shows that Bear market alarms produced using the above methods are rare, yet the alarm never fails to sound when a Bear market is underway. No speculation, no comparison to disasters such as the Crash of '29, just advance warning when it's needed most.

    A few areas of interest on the chart include:

    • Identification of the beginning of the Mini-Bear market of 2011 on August 5, 2011 at S&P 1199 and its end on November 18, 2011 at S&P 1215 avoiding the intervening low of S&P 1122
    • Identification of the beginning of the Mini-Bear market of 2010 on June 25, 2010 at S&P 1076 and its end on August 20, 2010 at S&P 1072 avoiding the intervening low of S&P 1010
    • Identification of the beginning of the Crash of 2008 on July 11, 2008 at S&P 1239 and its end on January 23, 2009 at S&P 831 avoiding the intervening 400 point decline, albeit prematurely signaling the true end of that particular Crash by 30 days. Even so, only the final 150 points of losses for the S&P occurred during those 30 days, and a trader who bought stock could have avoided most or all losses associated with that final 150 point loss by selling ATM Covered Calls against each stock position. Covered Call sellers are always the first traders to become profitable when a Bear market ends.
    • Very few Bear market false alarms were generated, most notably on June 1, 2012 and July 6, 2012, however a trader could easily have taken steps to avoid each of those nuisance signals, since each was triggered by the S&P being just 3 or 4 points inside the required range of a Bear market, too narrow a range to be meaningful considering the limits of error on the data are likely on the order of +/- 10 points.

    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.

    (click to enlarge)

    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 1903 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 1903 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.

    (click to enlarge)

    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 1995, Long Calls (and Married Puts) will remain profitable, suggesting the Bulls retain confidence and strength. Below 1995, 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.

    (click to enlarge)

    The LSSI currently stands at -0.5%, 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. Negative values for the LSSI represent losses for Long Straddle option trades. Small losses are quite normal and usual for Long Straddle trading.

    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 2041. Values above S&P 2041 would suggest a continuation of 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 2119 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 1925 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 1925 would be a major bullish "buy the dip" signal, while a break below 1905 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 OptionScientist@zentrader.ca

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  • The Bear Has Begun To Stir In Gold

    By Poly

    This is an excerpt from this week's premium update from the The Financial Tap, which is dedicated to helping people learn to grow into successful investors by providing cycle research on multiple markets delivered twice weekly. Now offering monthly & quarterly subscriptions with 30 day refund. Promo code ZEN saves 10%.

    When considering whether an asset is ready to turn higher, I generally look for an extreme negative sentiment level during an extreme price decline while the asset is in the timing band for a Cycle Low. At present, both Gold and Silver sentiment are approaching extremes, likely indicating that an ICL is near.

    But let's consider the chart from a broader perspective with the following question: Since this is just week 15 of the current IC, are there enough bears to lead us to believe that an IC low is near? In a bull market, low sentiment is a great predictor of a turn. But if Gold is still in a bear market, or even if it's in a more neutral bottoming period, sentiment might not be negative enough yet for an ICL.

    (click to enlarge)

    The same logic applies to the COT report (below). Speculators have not yet taken short positions as at other recent Cycle ICLs, suggesting that there is short selling ahead.

    As bearish as this sounds, there is a "rest of the story" in support of my view that we're still at a major decision point for Gold. If June 2013 was the final capitulation low that ended the bear market, and I still believe that it was, it was followed by a retest in Dec 2013. Each ICL since has attracted fewer Short speculators and far less hedging…and that's not bear market behavior. Such apathy and disinterest is often observed at - or after - bear market lows.

    (click to enlarge)

    Given the cross-currents, I stand by my work and maintain that no analysis can predict Gold's direction until the consolidation zone is resolved. The best stance at present is to be neutral with a "wait and see" bias. It's a cliché, but cash is a position.

    Although my official stance toward Gold is neutral, my analysis has been tilting more heavily bearish in recent weeks…and for good reason as it turns out. Gold closed this past week below $1,240, which was the last ICL, so an Investor Cycle failure is in play. The implication, of course, is that Gold is in longer term decline. It also means that the Yearly Cycle (which started in June 2013) is in decline and moving toward a YCL.

    It seems that every analyst and blog are now focused on $1,179 - the current bear market low and 2013's Yearly Cycle Low - and how Gold is likely to fall below it. The massive triangle patterns sported by the Gold and Silver charts have gone mainstream. From a contrarian standpoint, such obvious commentary could wind up working in the precious metals' favor; broadly held expectations often end up over-crowding a trade. In this case, a contrarian might expect a surprise turn and an early ICL.

    We can't say for sure what will happen. Through the past 13 years and more than 35 Investor Cycles, ICLs formed 10 times between weeks 15 and 18 - essentially where we are at present. Technically, all the readings we look for at major Cycle Lows are in place today. So although the weekly Cycle count is relatively early, there is absolutely enough precedent here to support an ICL. Supporting this position are the Miners, which are simply refusing to fall - normally by this point in a bearish Investor Cycle, they would be getting murdered.

    (click to enlarge)

    In closing, I circle back to a recurring theme…that the evidence currently supports both bullish and bearish views. With Gold still in a well-established triangle pattern, the uncertainty is not surprising. This week, however, the bear has begun to stir, with Gold pushing lower and taking out a key Cycle pivot. The current set up is undeniably negative, and odds are that we are still several weeks from an ICL. So the only prudent expectation here is to the downside. The downside case is supported by the current trend, and a test of the last Yearly Cycle Low (June 2013) at $1,179 is likely coming. That is the last line of support for Gold and potentially where the bulls will mount an attack.

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  • Options Witching Effects On Stock Prices

    By Chris Ebert

    These days, there are lots of different options expirations available, so no single expiration is quite as important as it may have been in the past when availability was much more limited. Even so, some options expiration dates, such as September 20, 2014 are more significant than others because they coincide with expirations of other derivative contracts, namely futures.

    When the expirations of options and futures coincide - generally on the third Friday of March, June, September and December - the effect on the stock market can be magnified. The term witching is often used synonymously for the final hour of expiration. Triple-witching or quadruple-witching simply refers to the number of options or futures expiring at the same time.

    Witching occurs this Friday, September 20.

    To understand the potential effects of witching this week, it may be helpful to take a look at the reasons that options expiration can affect stock prices. Once the reasons are known, it should become easier to notice the effects, thus allowing trader to differentiate those effects, which are generally temporary, from the effects of broader-market forces, which may be more permanent.

    Nobody likes to be stopped out of a stock during witching only to have the stock reverse when the effect of witching disappears the following week. The following analysis looks specifically at this Friday's options witching on the S&P 500. To begin, it is important to know what types of options are currently profitable.

    (click to enlarge)
    Click on chart to enlarge

     

    * All profits are calculated at expiration, as a percentage of the underlying SPY share price. SPY is an Exchange Traded Fund (NYSEMKT:ETF), the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) that closely tracks the performance of the S&P 500 stock index. All options are at-the-money (ATM) when-opened 4 months (112 days) to expiration. (e.g. Profit of $6 per share on an expiring Long Call would represent a 3% profit if $SPY was trading at $200, regardless of whether the call premium itself actually increased 50%, 100% or more)

    You are here - Bull Market Stage 1 - the "Digesting Gains" Stage.

    (click to enlarge)
    Click on chart to enlarge

    On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending September 6, 2014, this is how the trades performed on the S&P 500 index ($SPY):

    • Covered Call and Naked Put trading are each currently profitable (A+).
      This week's profit was +2.6%.
    • Long Call and Married Put trading are each currently profitable (B+).
      This week's profit was +1.9%.
    • Long Straddle and Strangle trading is currently not profitable (C-).
      This week's loss was -0.8%.

    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 significant pullbacks, as if traders are taking time to digest each individual gain. Digestion is often bullish, but not nearly as bullish as the lottery fever of Stage 1 of recent weeks.

    It is important to note that a return to lottery fever often cannot be confirmed until it has been in place for at least a week. Thus, the S&P would need to rally this coming week (ending Sept. 20) as well as the following week (ending Sept. 27) in order for a new case of lottery fever to be confirmed.

    A chart describing all of the different Options Market Stages is available by clicking the link at the left.

    Think like an Option Trader

    To understand the effects of option expiration (witching) requires empathy for option traders - a valuable exercise even for stock traders who've never traded a single option. Consider the following:

    • How would I feel if I sold Naked Puts (or Covered Calls) and stock prices fell below the strike price going into expiration?
    • What about if I sold Naked Calls (or Covered Puts) and stock prices rose above the strike price?
    • What if I bought Calls or Puts and they ended up in-the-money (NYSEARCA:ITM) near expiration?

    Let's start with that last one. Most likely if a trader buys Calls it is because there is an expectation that the stock price will rise. It is true Long Calls may also be used as protection for short stock position, as a sort of stop loss. However, in general a buyer of a Call expects to profit when the share price rises by using the Call to purchase shares of stock at a bargain price (the strike price) when the stock price has moved higher.

    For example, if I buy one standard Call option at the $100 strike price and the stock price rises to $105, I can exercise that Call option and buy 100 shares of stock for $100 a share, even though it is trading at $105 per share on the open market. That's a bargain! Even if I don't necessarily want to own the stock, I can use the Call option to buy the stock at a bargain and then sell it on the open market for an instant $5 profit (although profit is reduced by the cost of the Call option of course).

    The same is true if the stock price falls below the strike price and I own a Put option. For example, if I buy one standard Put option at the $100 strike price and the stock is trading at $95 on expiration day, I can exercise the Put option and sell 100 shares of stock at $100 even though it is trading at only $95 on the open market. That's a bargain too! Even if I don't own the stock, I can buy it on the open market for $95 and use the Put option to sell it at the strike price of $100, an instant $5 per share profit (although profit is always reduced by the initial cost of the Put option).

    In either case, if I own a Call or a Put and the strike price is out-of-the-money at expiration, the option is worthless. There is no bargain in exercising a $100-strike Call option if the stock price is $95, just as there is no bargain in exercising a $100-strike Put option if the stock price is $105. Out-of-the-money options are worthless when they get to expiration. The only reason they ever have value is because they might be worth something someday. When expiration day arrives, the time is up; therefore on expiration day all out-of-the-money options lose whatever remaining value they might have.

    Out-of-the-money (OTM) Options at Expiration

    Out-of-the-money options become worthless on expiration day, and that's great for the folks who sold such options because they get to keep whatever premium was collected. For example, if I sell a $100-strike Call option for $2 per share, and the stock price subsequently falls to $95 on expiration day, the option will become worthless and I will keep the $2 per share premium. That's great for me - not so great for whoever bought that particular option from me.

    If I buy an option and it is out-of-the-money at expiration, I lose any chance of recovering the cost of that option because time has run out - the option is worthless, permanently. When a trader buys an option that expires worthless, the result is a loss on the option. Even so, the loss on the option is limited. The buyer of an option can never lose more than the initial premium paid. If I buy a Call option for $2 per share, my loss can never be greater than $2 per share because the absolute worst thing that can happen is for the option to go to zero, if it expires out-of-the-money, worthless.

    Out-of-the-money options at expiration give option sellers a limited gain, since their gain is limited to the premium they collected. OTM options give option buyers a limited loss at expiration, since their loss is limited to the premium they paid. In either case, whether buyer or seller, the gain or loss is limited; thus OTM options are not likely to induce major changes in stock prices at expiration. Major changes tend to come from traders trying to limit their losses, something that doesn't much affect either buyers or sellers of OTM options on expiration day.

    In-the-money (ITM) Options at Expiration

    In-the-money options are good for buyers when expiration day arrives. One standard ITM Call option at expiration will cause the owner of that option to automatically buy 100 shares of the underlying stock. The price per share will be the strike price of the Call; and the strike price is always lower than the current share price when a Call is ITM.

    There is no compelling reason for the ITM Call owner to take any action at expiration, unless he or she does not want to own the stock. But, in the case in which stock ownership is not desired, the Call can be sold before it expires, often at a profit, rather than taking possession of 100 shares of stock and then selling those shares at a profit. The owner of an ITM Call therefore does not normally influence the stock market to any great degree on expiration day, because he need not trade any shares of stock to go long (he just keeps the Call open) and he need not trade any shares of stock to close his long position (he just closes the Call).

    One standard Put option at expiration will cause the owner of that option to automatically sell 100 shares of the underlying stock at expiration. Again, the owner has the ability to sell the option before it expires in-the-money, thus avoiding unwanted exercise and the sale of 100 shares of stock. The owner of an ITM Put, therefore has little influence on the stock market at option witching. He just keeps the Put open to close a long stock position or to initiate a short, or else closes the Put to remain long or to avoid going short on the stock - either way, no shares need be traded before expiration occurs.

    There are a few ways ITM option owners may have a minor effect on stock prices on expiration day. Option exercise can result in large capital requirements, so traders may short stock in a rally near expiration to make room for shares that will be obtained by exercising an ITM Call option. Some may buy shares in a sell-off near expiration in order to sell those shares by exercising an ITM Put option.

    In either case, Holders of ITM options may thus reduce volatility slightly on expiration day, since shorting stocks on a rally (to make room for shares from a Call exercise) can add selling pressure that may limit the rally while buying stocks on a sell-off (to obtain shares for a Put exercise) can add buying pressure that may limit the sell-off, but the limiting effect is generally small. In most cases, such stock trading is only required when liquidity has dried up on the ITM options, making it impossible for the option holder to simply sell the option, at least not at a fair price. If liquidity is good, the option is usually easier to sell than to exercise.

    The seller of an ITM option may have the biggest influence of all on expiration day, and here's how. Option sellers, also called option writers, have no say in whether the options they sold will get exercised and assigned. Exercise is the buyer's decision - the buyer's option. That's why they are called options.

    For the seller, the option is actually an obligation. A seller of one standard Call option is obligated to sell 100 shares of stock on expiration day, at the strike price, if that option expires in-the-money. The shares will simply be called out of his account.

    The seller of one standard Put option that is ITM at expiration is obligated to buy 100 shares of stock at the strike price. The shares will simply be put into his account.

    Because of this obligation, it behooves sellers of ITM options to take steps to ensure their account is prepared to either have shares called away, or shares put in it on expiration day. The simplest way for a Call seller to prepare to have shares called away is to buy sufficient shares on expiration day to meet the obligation; and the simplest way for a Put seller to prepare is to short enough shares on expiration day to make room for those that will be put on him.

    Witching Hour

    (click to enlarge)

    An expanded 10-year historical chart is now available.

    By the time the final hour of trading has arrived on the third Friday of March, June, September or December, most of the attention in the stock market is focused on traders meeting their obligations.

    Options sellers often must short shares if stock prices have fallen unexpectedly, in order to make room for shares about to be put on them from ITM Put options. If stock prices are up unexpectedly, they may need to purchase shares to meet their obligation by having enough shares on hand to have them called away.

    Whether stock prices are down or up, the obligations of option sellers tends to magnify the trend. Selloffs can become magnified by Put sellers shorting shares to make room for those about to be put on them. Rallies can be magnified by Call sellers buying enough shares to have some called away. This is especially true when stock prices make a large move on expiration day, causing option sellers at OTM strikes to suddenly find themselves ITM and in dire need of enough long or short shares to either meet their obligation (short Calls) or make room for delivery (short Puts).

    As mentioned previously, major changes at option witching tend to come from traders trying to limit their losses - sellers of Calls buying shares to limit losses when stocks shoot higher, sellers of Puts shorting shares to limit losses when stock prices tumble. Option owners can just sit on their profits if they suddenly find themselves ITM at witching.

    On witching Friday:

    • OTM buyers have no immediate need to trade stock since their loss is at a maximum and cannot increase at expiration
    • OTM sellers have no immediate need to trade stock since they will experience maximum gains at expiration
    • ITM buyers have no immediate need to trade stock since they will experience a gain on the stock at expiration
    • ITM sellers do have an immediate need to trade stock since it may be the only way to cut losses let alone meet option obligations

    September 19, 2014 3:00 PM EDT

    When the witching hour begins this week, option sellers will need to take the steps outlined above if their positions are in-the-money. Since the trend has largely been upward for the past several months leading into Friday's expiration, many Call options that were initially opened OTM - some may have been opened several months ago - will likely be ITM. Of those ITM Calls, many will likely be closed before Friday, if they were not already closed weeks ago.

    The S&P 500 has risen nearly 100 points in the past 4 months, so a lot of Call option strike prices that were out-of-the-money at that time are now in-the-money. A lot of Put options that were in-the-money or at-the-money are now out-of-the-money. The question this Friday is whether all the remaining OTM Call sellers will suddenly find themselves in-the-money and therefore in need of long shares, possibly driving a rally to new all-time highs. Or, it's a question of whether the remaining OTM Put sellers will suddenly find themselves in-the-money and in need of short shares, possibly driving the sell-off even deeper.

    As can be seen in the chart above, if stock prices climb above the blue line (currently near the 2020 level for the S&P) by Friday then it would likely take a lot of OTM Call sellers by surprise and they might be forced to hastily buy shares when their Calls end up ITM, which could drive a return to Bull Market Stage 1 "Lottery Fever" and set stocks up for new record highs in the S&P in the coming weeks.

    If stock prices fall below the yellow line (currently near the 1972 level) by Friday then it would likely take a lot of OTM Put sellers by surprise and they might be forced to short shares when their Puts end up ITM, which could drive a return to Bull Market Stage 3 "Resistance" and set stocks up for a brick wall of resistance for the S&P in the coming weeks, at the recent high near the 2010 level.

    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.

    (click to enlarge)

    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 1875 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 1875 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.

    (click to enlarge)

    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 1972, Long Calls (and Married Puts) will remain profitable, suggesting the Bulls retain confidence and strength. Below 1972, 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.

    (click to enlarge)

    The LSSI currently stands at -0.8%, 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. Negative values for the LSSI represent losses for Long Straddle option trades. Small losses are quite normal and usual for Long Straddle trading.

    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 2020. Values above S&P 2020 would suggest a continuation of 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 2097 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 1905 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 1905 would be a major bullish "buy the dip" signal, while a break below 1905 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 OptionScientist@zentrader.ca

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