By Chris Ebert
Here it is! The all-new Stocks and Options at a Glance.
With just one look, it is now possible to see exactly which option strategies are currently profitable and which are not. Those who use option performance as a technical indicator can now see where the stock market is now (as measured by the S&P 500 index) and where it is likely to go next, with a simple "You Are Here" marker.
This week's profitable strategies* are:
- Covered Calls
- Naked Puts
- Long Calls
- Married Puts
- Long Straddles
- Long Stangles
(click to enlarge)Click to enlargeClick on chart to enlarge
This week's losing strategies* are:
- Long Puts
- Married Calls
- Naked Calls
- Covered Puts
- Short Straddles
- Short Strangles
*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)
You Are Here - Bull Market Stage 1
Stocks are now in Stage 1 of a mature bull market. Bull markets tend to progress from stage 0 to stage 5 and then repeat the process, beginning again at stage 0. There is no limit to the number of times the process can be repeated, so a bull market may continue indefinitely, until at some point in the future Stage 5 fails to materialize. Stage 1 represents an over-extended market, which often precedes a correction.
Often the correction occurs quickly, within weeks of Stage 1 being reached. Occasionally, however,the market gets "lottery fever" and buyers start coming in from the sidelines, even though the market is over-extended. When this happens, a healthy correction can be postponed for weeks, sometimes months.
Stage 1 represents a point where newspapers, television newscasts and other media begin to run headlines about the raging bull market currently underway. These headlines tend to lure more money into the market, some of it from folks who may have little or no idea how market cycles work. The fact is, over the past 10 years, Stage 1 has rarely lasted more than 4 months. Given that the current Stage 1 began on March 9th, chances are pretty good that it will be over by the time July rolls around.
To put the ridiculous nature of the current bull market into perspective, one need only look at the recent performance of long straddle option trading. For those unfamiliar with straddles, it is equivalent of betting that the market will go up while also betting that the market will go down.
To put it another way, it's like betting on both teams in a sporting event, or betting on every horse at the track at the same time. Not only has long straddle trading has been returning profits since March 9th, those profits have at times exceeded 4% - a remarkable accomplishment.
So, what happens next?
Sometime soon, most likely prior to July, the market will enter Stage 2, at which point long straddle trading will no longer be profitable. After that, Stage 3 will see long call trading relinquish its former profitability. Then at Stage 4, even the most conservative of bullish option strategies, covered call trading, will fail to return profits; and that's when the market must make an important decision.
If one looks at Stages 0 through 4 of a bull market, it can be seen that they are identical to stages 0 through 4 of a bear market. The end of stage 4 in a bull market can therefore be followed either by a rally which continues the bull market, or a sell-off that confirms a new bear market.
It should be noted that there is no time limit on any of the stages. Each stage may last for weeks or months, but it is also possible for the market to blow through several stages in a matter of days, or in the case of a black swan or market crash, in a matter of hours.
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 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.
This week, covered call trading and naked put trading were both profitable, as they have been for an extended period. That means the Bulls remain 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.
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.
This week, long call trading and married put trading were both profitable. Both forms of trading became profitable in late January. It means the Bulls are not only in control now, but they are confident and strong. 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, but they are 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 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.
On March 9th, long straddle trading and long strangle trading reached rare and absurd levels of profitability. Such levels normally precede a correction. That does not preclude a possible move higher prior to the correction though.
Just because the LSSI is warning of an upcoming correction does not necessarily mean that this is a good time to go short. It just means that the market cannot continue at its current pace without running out of buyers. Often a correction occurs within a week of the LSSI exceeding 4%, but there are times when the market tacks on several weeks or months of large gains before it corrects.
Since March 9th the market has indeed tacked on several weeks of impressive gains, with the Dow and the S&P both reaching new all-time highs. Is the current market irrational? Yes. Is such irrational behavior unexpected? Not at all. Every market goes through phases of irrationality, and each phase eventually ends with a reversion to more rational behavior.
The current market is well overdue for a correction. The current rally is living on borrowed time. The correction will occur, eventually, but betting on a correction could potentially lead to bankruptcy. An elevated LSSI has always led to a correction in the past, and there's no reason to suspect this time will be an exception. It's just a matter of how long until it occurs. 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 only been going up quickly, but have gone up surprisingly fast." Profits warrant concern that the market may be becoming over-extended, 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 uptrend has been ridiculous and unsustainable." No matter how much strength the Bulls have, they have pushed the market too far, too fast, and it needs to correct
*Option position returns are extrapolated from historical data deemed reliable, but 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.
Questions, comments and constructive criticism are always welcome. Enter them in the comment box below, or send them to OptionScientist@zentrader.ca.
The preceding is a post by Christopher Ebert, who uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. He studies options daily, trades options almost exclusively, and enjoys sharing his experiences. He recently co-published the book "Show Me Your Options!"
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