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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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  • Jobs Fail, Stocks Rise, Options Explain Why 0 comments
    Jan 13, 2014 12:32 AM

    By Chris Ebert

    There isn't much to say this week regarding the ability of stock options to predict the reaction of stock traders to troubling economic news. The options speak for themselves.

    Take a disappointing employment number, which at best might be considered poor news, even if such a number was expected, and add it to the fact that the number came as a surprise to most traders. From such a bad number combined with the negative aspect of its surprise one could infer that the economy had unexpectedly weakened, or was about to weaken, and that future corporate earnings could potentially suffer as a result. From all of that, one could easily conclude that the stock market was in for a rather large sell-off.

    But instead, upon the release of this unexpectedly horrendous news, stock prices generally rose, pushing the S&P 500 up a few points.

    The number of new jobs was reported at around 75,000, certainly a disappointing number when considering the potential future impact on the economy. Besides disappointment, that number was downright surprising considering the consensus among the employment experts was an expectation of 200,000 or so new jobs. The experts were not even in the ballpark!

    That stock prices can rise in the face of disappointing news is understandable… well at least for those who study options it is understandable. Stock options are indicating, and have been indicating for several months, that stock traders are currently extremely bullish, so bullish that they have developed an almost-Pavlovian response to any dip in stock prices - they BUY THE DIP!

    Known here as Bull Market Stage 1, the current market is filled to the brim with buy-the-dip traders. Following is an in-depth analysis of the current buy-the-dip mentality and what it means for the stock market in the upcoming weeks and months.

    (click to enlarge)Click 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 the most bullish stage possible for the stock market. It is generally a market of rising stock prices. Since the uptrend is so strong during Stage 1, any pause in that trend tends to be short-lived. Whether stock prices stop rising and trend sideways (consolidate) or decrease slightly (pullback) for a few days or a week or so, the trend quickly resumes before it becomes a major pullback (correction). This process, repeated over and over, conditions traders to buy stocks whenever there is a dip in prices.

    The sheer number of buy-the-dip traders tends to prevent any single dip from becoming a major correction. Although a Bull-market correction can be a healthy part of any stock market cycle, a lack of corrections is not necessarily unhealthy for the market. That is to say - stock market euphoria sometimes continues for several months at-a-time without any apparent damage to a Bull market.

    Such euphoria can appear to defy common sense from time to time, such as when horrible economic news fails to send stock prices tumbling. However, it is vital to remember that the stock market is not the economy and the economy is not the stock market. Thus, as long as Bull Market Stage 1 continues, it will likely remain profitable for traders to buy stocks or to enter bullish option trades, whether or not economic developments overtly seem to support such trades.

    Recognizing whether the stock market is currently at Stage 1 requires a quick analysis of the 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 2.9%.
    • Long Call trading is currently profitable (B+). This week's profit was 4.9%.
    • Long Straddle trading is currently profitable (C+). This week's profit was 2.0%.

    The combination, A+ B+ C+, occurs whenever the stock market environment is at Stage 1.

    For a complete description of all Option Market Stages, click here.

    What Happens Next?

    As long as Bull Market Stage 1 continues, there isn't much question about what the stock market will do next - stock prices will continue to trend upward. Thus, the only concern right now is what it would take to push the market away from Stage 1.

    On the following chart, Stage 1 is represented by all of the area above the blue line - currently at a level of about S&P 1800, rising to a level of about 1850 in February and 1900 by March. So, as long as the S&P does not fall below 1800 through the end of January, Stage 1 will continue; and as long as Stage 1 is in progress, the expectation is for the uptrend to continue.

    • Quite simply: S&P above the blue line is an extremely bullish sign.

    Although anything above the blue line is bullish, anything above the green line signals that the market is overheated. If the uptrend becomes so absurd that it surpasses the green line near 1900 through the end of January, a pullback could ensue in order to cool things off a bit. Thus, Stage 1 is most sustainable if it remains below the green line.

    • S&P above the green line is too bullish to be sustainable.

    (click to enlarge)

    There are several ways that Bull Market Stage 1 could end, each with the potential to curtail, at least temporarily, the current buy-the-dip mentality:

    • If the S&P experiences a sudden pullback to the 1800 level in January, that level would be below the blue line on the chart, and the market could enter Stage 2.
    • If the S&P gets stuck at its current level around 1850 for several weeks, the market could potentially enter Stage 2 in February.
    • If the S&P continues rising, but fails to surpass 1900 by mid-March, Stage 2 could potentially begin.
    • If the S&P suddenly rallies above 1900 prior to February, it would be above the green line on the chart, in an area that represents unsustainable growth that often precedes a sell-off.
    • If the S&P rallies above the 1950-2000 range prior to the end of March, it would be above the green line and potentially due for a Bull-market correction.

    In any case, if the S&P leaves Stage 1, the stock market will likely not be as dependably bullish as it has been recently. For the remainder of January, that means anything outside of the 1800 to 1900 range demands attention.

    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.

    (click to enlarge)

    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 1634 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.

    (click to enlarge)

    Long Call trading was profitable for almost all of 2013 except for a brief break from August through early October, and remains profitable today. As long as Long Call trading remains profitable, 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 1749 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.

    (click to enlarge)

    The LSSI currently stands at +2.0%, which is slightly higher than average, but still within normal limits. Excessive profits on Long Straddle trades, such as those exceeding 4%, will not occur this coming week unless the S&P rises above 1874. 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. Even if the LSSI does not exceed +4.0% this coming week, the fact that the LSSI recently exceeded +4% a few weeks ago makes some sort of pullback or a correction a distinct possibility for the next several weeks, although that possibility tends to decrease as time passes. Excessive losses on Long Straddle trades, such as those exceeding 6% will not occur this coming week unless the S&P falls to 1705. 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


    Related Options Posts:

    Covered Call Trading In 2013 Has Zero Losses

    Real Reason Stock Market Is Full Of Silver Linings

    Stock Market's Lottery Fever May Hit The Jackpot

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