By Chris Ebert
The stock market is in an odd place. A roaring Bull market is underway - that's a good thing. But, the pace of the recent uptrend in stock prices has been surprisingly fast - and that's not such a good thing.
As with any trend, when the pace becomes unsustainable the likelihood increases that the trend will end. During the normally-cold winter months, a temperature trend that pushes the mercury up slowly, from a frigid 0 degrees (32 F) to a mild 10 degrees (50 F) may be sustainable for days upon days. Even if such a temperature is higher than might be expected for the time of year, it is not so high that it is unsustainable over a long period of time.
If, however, the temperature climbs to a toasty 20 (68 F) in the middle of a normally-snowy winter, chances are that the temperature trend is unsustainable and will soon end. Such is the case with the S&P 500, which has risen nearly 200 points in just 4 months (from September through December), a pace that is rare for a mature Bull market. Excessively-bullish markets are often as welcome as shirt sleeves in winter, but each soon disappears.
The pace of the recent uptrend in the S&P became especially noteworthy this past week, as it caused Bull Market Stage 1 to exceed a limit that historically has been associated with pullbacks, and occasionally, all-out Bull market corrections, in the weeks immediately following the broken limit.(click to enlarge)Click to enlargeClick on chart 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)
You Are Here - Bull Market Stage 1
Bull Market Stage 1 is known here as the "lottery fever" stage of the stock market, being a reference to the similarities of the current buying going on in the stock market to the manic buying of lottery tickets which often precedes lottery drawings when the jackpot is unusually large.
In the stock market, the presence of lottery fever may be detected by analyzing three categories (A, B, and C) of option strategies shown in the chart above, using a plus (+) for profitable strategies and a minus (-) for unprofitable ones.
- Covered Call trading is currently profitable (A+). This week's profit was 3.5%.
- Long Call trading is currently profitable (B+). This week's profit was 7.8%.
- Long Straddle trading is currently profitable (C+). This week's profit was 4.3%.
The combination, A+ B+ C+, occurs whenever the stock market environment is at Stage 1. Normally Stage 1 during a Bull market is an indication that stock prices will tend to climb in the following weeks. However, there is a limit to how quickly stock prices can rise during Stage 1. Generally, profits on Long Straddle trading do not exceed 4.0%, so the reading of 4.3% registered this past week is an indication that the stock market has exceeded the upper limit of Stage 1. So, rather than Stage 1 indicating a tendency for the roaring Bull market to continue over the next several weeks, the exceedance of the limit is an indication that the market may be at or very near a temporary top, or at least ready to take a break.
For a complete description of all Option Market Stages, click here.
What Happens Next?
The chart below shows the performance of the S&P compared to the Option Market Stages for the entire trading year of 2013. It can be seen that the S&P rarely exceeds the upper limit (green line) of Stage 1 lottery fever, and that when it does the consequence can be a subsequent pullback in prices. This correlation exists not just for 2013, but for at least the last 10 years, and can be seen on a chart of the Long Straddle/Strangle Index (#LSSI) that follows.
The excessive profits of Long Straddle trading this past week (+4.3%) are an indication that the stock market has risen faster than many folks expected. In order to bring the uptrend back to a more reasonable and sustainable pace the S&P must do one of several things:
- The pace of the uptrend must slow down considerably over the next several weeks
- The uptrend must take a temporary break for a week or so
- Prices must experience a significant pullback
If the stock market complies with the above, and returns to a sustainable pace, then it is possible that Bull Market Stage 1 lottery fever may continue uninterrupted. By extending the above chart into early 2014, it can be seen that a healthy Bull market has the potential to push the S&P to near 2000 (green line) by April.
If, however, the current Bull market becomes unsustainable, the S&P could potentially test for support near 1750 (red line) in early 2014. Such a level would represent a healthy, and for many a long-overdue and welcome Bull market correction. As always, a Bear market often looks like a correction when it begins. For that reason, it is important to note that anything below about 1750 on the S&P in the first few months of 2014 is indicative of a Bear market, and suggests that something not-so-healthy may be underway.
Weekly 3-Step Options Analysis:
On the chart of "Stocks and Options at a Glance", option strategies are broken down into 3 basic categories: A, B and C. Following is a detailed 3-step analysis of the performance of each of those categories.
STEP 1: Are the Bulls in Control of the Market?
The performance of Covered Calls and Naked Puts (Category A+ trades) reveals whether the Bulls are in control. The Covered Call/Naked Put Index (CCNPI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames. Most important is the profitability of these trades opened 112 days prior to expiration.
Covered Call trading did not experience a single loss in 2013, 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 today. As long as the S&P remains above 1635 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. 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.
Long Call trading was profitable for almost all of 2013 except for a brief break from August through early October. As long as Long Call trading remains profitable, as it did this past week, the Bulls will retain confidence and strength. That very confidence is what allowed so many new records to be set for the S&P in 2013. Only if the S&P closes the upcoming week below 1741 will Long Calls (and Married Puts) fail to profit, suggesting the Bulls have lost confidence and strength. The reasoning goes as follows:
• "If I can pay the premium on an at-the-money Long Call or a Married Put and still manage to earn a profit, then prices have been going up - and going up quickly." The Bulls are not just in control, they are also showing their strength.
• "If I pay the premium on a Long Call or a Married Put and fail to earn a profit, then prices have either gone down, or have not risen significantly." Either way, if the Bulls are in control they are not showing their strength.
STEP 3: Have the Bulls or Bears Overstepped their Authority?
The performance of Long Straddles and Strangles (Category C+ trades) reveals whether traders feel the market is normal, has come too far and needs to correct, or has not moved far enough and needs to break out of its current range. The Long Straddle/Strangle Index (LSSI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames. Most important is the profitability of these trades opened 112 days prior to expiration.
The LSSI currently stands at +4.3%, which is much higher than average, and at a level rarely seen during a Bull market. Such levels suggest that option traders have not had a good handle on predicting the future. Excessive profits on Long Straddle trades, such as those exceeding 4%, will continue this coming week unless the S&P remains below 1861. Anything higher than that is likely to result in some selling pressure, and historically has been associated with subsequent pullbacks and, occasionally, Bull-market corrections. The fact that the LSSI already exceeded +4% this past week makes some sort of pullback or a correction a distinct possibility for the next several weeks. Excessive losses on Long Straddle trades, such as those exceeding 6% will not occur this coming week unless the S&P falls to 1692. At or near that level a subsequent breakout is likely. 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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