By Chris Ebert
Stocks and Options at a Glance
After several months of a stock market stuck in the "lottery fever" stage, there is now a possibility that the market is moving on to the something different - the "digesting gains stage".
A change in stages is not just important for option traders; it also marks an important change in how stock prices tend to react. Long Straddle trading* has recently been profitable and now there's a chance it could become unprofitable very soon, perhaps within days. While that change may go unnoticed to many, the consequences of that change will affect everyone.
Stage 1 of a Bull market, also known as the lottery fever stage, represents somewhat of a bubble. It is where stock prices are going up, sometimes for no other reason than, as ridiculous as it may seem, that stock prices are going up. Sometimes gains beget gains, and it's all a natural part of the stock market cycle.
Stage 2 is known as the "digesting gains stage", in which prices tend to pull back or move sideways for a time. While we are technically not there yet, a level of the S&P below 1600 in the next week or two would put us there, because that is the point where Long Straddle trading* would turn unprofitable.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 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 may be repeated, so a Bull market has the ability to continue indefinitely, until at some point in the future Bull Market Stage 5 fails to materialize, and instead Bear Market Stage 5 takes its place.
Stage 1 represents an over-extended market, which often precedes a correction. This stage has one very distinctive characteristic; all trades labeled with a "+" are profitable.
- A+ trades (Covered Calls and Naked Puts) areprofitable.
- B+ trades (Long Calls and Married Puts) are profitable.
- C+ trades (Long Straddles and Long Strangles) are profitable.
What Happens at Stage 2?
When a Bull market reaches stage 2, which as mentioned earlier would likely occur if the S&P falls below 1600, it marks an important change in options trading.
- A+ trades (Covered Calls and Naked Puts) remain profitable.
- B+ trades (Long Calls and Married Puts) remain profitable.
- C+ trades (Long Straddles and Long Strangles) begin returning losses.
This has implications for stock traders as well as options traders. Price patterns tend to be different in Stage 2. Where the market often used to experience a dip in the morning, followed by an afternoon rally fueled by "buy the dip" traders, now those traders are not as quick to buy. Instead, the market may start to appear as if controlled by "sell the rip" traders, where morning strength can sometimes be followed by surprising sell-offs.
Possibly more important, however, is that the next logical step upon reaching Stage 2 is for the market to progress to Stage 3, aka "the resistance stage", in which it becomes clear to all traders that the recent highs of Stage 1 now represent significant resistance. Following that is often another logical step. If the market knows where resistance lies, then it may test for support.
Think about this: If you bought a stock at $80 per share and the price suddenly climbed to $100, wouldn't you feel more comfortable buying additional shares of that stock if you knew there were bargain hunters waiting to jump in and buy it at $90? When traders begin to ask themselves this question on a widespread basis, on the basket of stocks that makes up the S&P, then the market tends to enter stage 4. Everyone recognizes Stage 4, it is the well known "correction stage"; and we can't get from here to there without going through Stage 2 first.
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.
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, 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.
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. Although rare, the market can, and historically has added gains for as long as 4 months or so, even after the LSSI has indicated that the market is "Due for a Correction"
On May 11th, the LSSI again exceeded the +4% limit that normally precedes a correction. While no technical indicator is correct 100% of the time, over the past 10 years a correction of at least 5% to 10% in the S&P has always ensued within 4 months or so after the LSSI initially topped 4%.
The LSSI has since backed off, standing at just 1.7% this week. If the S&P falls below 1600 that would mark the end of the recent winning streak for Long Straddle traders and Long Strangle traders - an historically long streak that began on March 9, 2013.
The correction will occur, eventually. 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 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 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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