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Jeff Pierce
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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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  • Market Timing Signal: Clear Skies Ahead

    By Jeff Pierce

    The general markets have been on shaky grounds per my timing signal in March - June and while the markets have rallied since then it just as easily could have gone the other way. Trade setups were quite scare during that period, at least they were for me and the way I analyze bullish setups but things seem to be getting back on trace. With all my time frames and long term trend up it's more safe now then it has been in quite some time to commit a larger than normal amount to long trades and to be lightening up on any remaining shorts you may have.

    In May, both the Nasdaq and Djia made significant strides for the bulls but it was my longer term trend indicator that remained stubbornly bullish up until early July. With that now green I'm looking forward to earnings season to provide many new trading opportunities. If that doesn't happen and new leaders fail to emerge then we could have some trouble with the market going forward. Watch for clues and new leaders or lack of new leadership.

    Jul 15 9:59 AM | Link | Comment!
  • SDPI - IPO Watch

    By Jeff Pierce

    Recent IPO"s can be a great source of bullish setups if they start strong out of the gate. SDPI has rallied 75% after it's initial public offering and has come off a bit, but is holding most of those gains. In fact, right now it is forming a base from where it could springboard higher so keep this on your radar if you are looking for a bullish speculative play in the oil sector.

    Jul 10 10:15 AM | Link | Comment!
  • Proof S&Amp;P Won't Top 2050 Through August

    By Chris Ebert

    To summarize last week's market analysis (available HERE) buying Calls* (Long Calls) becomes more profitable than selling Puts* (Naked Puts) only in the strongest of strong Bull markets, identified here as Bull Market Stage 1 - the "lottery fever" stage. The name, lottery fever, is derived from the euphoric buying of stocks that drives stock prices higher and its similarity to the euphoric buying of lottery tickets that often causes a large lottery jackpot to grow even larger.

    This past week, ending July 5, 2014, the S&P 500 entered the lottery fever stage once again. Buying Calls is now more profitable than selling Puts, for the specific options described below.

    However, buying a Call will never be more profitable, on a dollar-per-share basis, than owning 100 shares of stock. Some Call options may come close; but the profit on the Call will always be lower than the profit on the stock. Nevertheless, there is a point at which Call buying becomes so very profitable that it actually becomes preferable to buying stocks. When it does, the result is somewhat obvious: folks stop buying stocks.

    The profitability of Call options thus imposes a limit on how high stock prices can climb over a specific period of time. That is why the S&P 500 can climb no higher than 2050 through the end of August, as will be shown in the following analysis.

    (click to enlarge)

    *All strategies involve at-the-money options opened 4 months (112 days) prior to this week's expiration using an ETF that closely tracks the performance of the S&P 500, such as the SPDR S&P 500 ETF Trust (NYSEARCA:SPY)

    The specific Calls that are important to this analysis are those that areat-the-money or ATM. ATM simply means the strike price of the option is the same, or very nearly the same, as the current stock price. Even more specific, this analysis is only concerned with ATM Call options traded on an instrument that tracks the S&P 500 index itself, such as SPDR S&P 500 Trust (NYSEARCA:SPY). Although the expiration date of the Calls is of relatively minor importance, only $SPY ATM Calls opened 4-months to expiration are used in the analysis. This choice of expiration reduces random noise that can be generated with shorter expirations, while avoiding overly sluggish results obtained from longer expirations.

    To begin the analysis, it can be seen in the chart above that the Calls described above (category B trades) are currently profitable (B+) for the buyer (Long Calls) and not profitable for the seller (Naked Calls).

    You are here - Bull Market Stage 1 - the "lottery fever" Stage.

    On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending July 5, 2014, this is how the trades performed:

    • Covered Call and Naked Put trading are each currently profitable (A+).
      This week's profit was +3.9%.
    • Long Call and Married Put trading are each currently profitable (B+).
      This week's profit was +3.9%.
    • Long Straddle and Strangle trading is currently profitable (C+).
      This week's profit was +0.0%.

     

    (click to enlarge)Click on chart to enlarge

    * All profits are calculated at expiration, as a percentage of the underlying $SPY share price, using options ATM-when-opened 4 months to expiration (e.g. profit of $6 per share would represent a 3% profit if $SPY was trading at $200).

    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 1, known here as the "lottery fever" stage because of its lottery-like euphoria. As mentioned earlier, buying Calls is always more profitable than selling Puts during Stage 1, although the difference this past week was so small - less than 0.1% - that it was not apparent, due to rounding.

    For a description of Bull Market Stage 1, as well as a comparison to all of the other market stages, see the chart on the left (click to enlarge):

    What Happens Next?

    The main advantage of owning a Call option is not that it returns larger profits than owning 100 shares of stock, because it doesn't. The profit is always smaller. Rather, the advantage is that the net loss, when there is a loss, can never exceed the initial Call premium paid, whereas losses on the stock can potentially continue until the stock price reaches zero. Owning a Call limits losses, owning a stock does not.

    Thus, there occasionally comes a point at which buying Calls is not only more profitable than selling Puts, but a point at which the difference in profit becomes so large that buying Calls starts to attract attention from folks who normally don't trade options. The options market can become so profitable, with such limited risk, that it can no longer be ignored.

    Historically, over at least the past 10 years of observations, the point at which at-the-money 4-month-to-expiration Long Call options become 4% more profitable than at-the-money Naked Put options is a major tipping point at which people not only stop selling Naked Puts, they stop buying stocks and start buying Calls.

    So, all that is necessary to find the point at which people will stop buying the stocks that make up the S&P 500 is to find the point at which at-the-money 4-month-to-expiration Long Calls, on an instrument that tracks the S&P 500, would earn a 4% greater profit than Naked Puts.

    The point at which people stop buying stocks can therefore be described as a simple algebraic equation:

    • LONG CALL PROFIT - NAKED PUT PROFIT = 4%

    Without adding too much confusion, a Naked Put means the trader is "short" a Put option. For example, if a trader sells 10 Puts, the position would be written as -10 Puts. A Naked Put position, as with any short position, is always a negative number.

    Subtracting a negative number is the same as adding a positive number. For example, to subtract a position of -10 Puts from a portfolio, the trader would add 10 Puts. Subtracting -10 is the same as adding 10. The same process applies to the above equation. Subtracting a Naked Put is the same as buying a Put (a Long Put). Thus the equation can be re-written:

    • LONG CALL PROFIT + LONG PUT PROFIT = 4%

    It truly is that simple. When a Long Call profit plus a Long Put profit is 4%, that is the turning point at which Long Calls become so attractive that there is little reason to take the risk of buying stock, and lots of reasons to take the limited risk of buying Calls.

    As many readers may have surmised, a Long Call plus a Long Put is a very common option trade known as a "Long Straddle", which can be substituted in the above equation.

    • LONG STRADDLE PROFIT = 4%

    Thus, when an at-the-money 4-month-to-expiration Long Straddle on the S&P 500 earns a 4% profit, that is the point at which traders will tend to stop buying stocks in the S&P 500 and start buying Calls. Long Straddle profits normally cannot exceed 4%. The effect of the 4% limit is clearly visible in January 2014 in the chart below.

    (click to enlarge)

    The green line in the chart above depicts a 4% profit, at expiration, on at-the-money Long Straddles on the S&P 500 that were opened 4 months earlier. The green line therefore represents the highest point that the S&P can climb, because that is the point where buying stocks becomes almost foolish, even with a stock's slightly higher profit potential than Calls, given the much lower risk of buying Calls. (For a historical perspective of the 4% rule, see the 10-year chart of the Long Straddle/Strangle Index (#LSSI) in the detailed analysis that follows.)

    The green line represents the upper limit of "lottery fever", and it is nearly impossible for the S&P to exceed that upper limit no matter how much euphoria a rally has infused into the stock market.

    Through the end of August, the green line almost always remains below approximately 2050. Therefore, it is almost certain that the S&P 500 will not climb above 2050 until September at the earliest.

    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 in 2014.

    As long as the S&P remains above 1805 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 1805 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 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. 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 1928, Long Calls (and Married Puts) will remain profitable, suggesting the Bulls retain confidence and strength. Below 1928, 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 +0.0%, 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 1990. Values above S&P 1990 would suggest a continuation of the current 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 2064 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 1878 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 1878 would be a major bullish "buy the dip" signal, while a break below 1878 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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    Related Options Posts:

    Selling Puts Vs. Buying Calls In Bull Markets

    Beware - Options Rank S&P Rally C-Minus

    How To Trade Without Watching The News

    Jul 07 12:56 AM | Link | Comment!
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