By Chris Ebert
Stocks and Options at a Glance
It looked as though the stock market was ready to change gears last week, and although it came close, it did not make the change. The market remains in Stage 1, also known as the "lottery fever" stage.
Stage 1 is a normal part of the stock market cycle, despite the fact that Stage 1 represents a market in which stock prices are rising at an abnormal and unsustainable pace. Euphoria-fueled rallies tend to occur at least once every year or two, and usually last no more than a few weeks before the market reduces the pace of the trend to a more sustainable rate. Stage 1 often ends with a minor pullback on the S&P on the order of 5%.
What makes the current Stage 1 abnormal is its longevity. While Stage 1 rarely lasts more than a few weeks, the current Stage 1 began over three months ago on March 1, 2013, making it one of the longest-lasting on record over the past decade. Historically, longer-lasting Stage 1 Bull markets have been followed by major corrections on the S&P of 10% or more, and occasionally, Bear market declines of 20% or more.
Bull Market Stage 1 - Longest lasting stages on record since Jan. 1, 2004
- #1) 21 weeks - Oct. 7, 2006 to Feb. 24, 2007. The S&P subsequently fell 3.5% in a single day on Feb. 27, 2007, part of a 5% pullback over the following week.
- #2) 15 weeks and counting - Mar. 1, 2013 to Jun. 7, 2013.
- #3) 13 weeks - Apr. 28, 2007 to Jul. 21, 2007. The S&P was within 25 points of its pre-crisis high and subsequently fell 7% by the first week of August 2007, part of a 50% decline over the following 20 months.
- #4) 12 weeks - Dec. 3, 2010 to Feb. 19, 2011 The S&P was within 25 points of its pre-correction high and subsequently fell 17% during the summer of 2011.
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 pointin 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) are profitable.
- B+ trades (Long Calls and Married Puts) are profitable.
- C+ trades (Long Straddles and Long Strangles) are profitable.
What Happens at Stage 2?
- 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.
The market neared Stage 2 this past week, and would have made the change if the S&P had fallen below 1600 and remained there. For the upcoming week ending June 15, 1610 is the magic number, and for the following week ending June 22 the number is 1621. Each of those levels represents the point at which Long Straddle and Long Strangle trading would become unprofitable.
Stage 2 represents a change in the pace of an uptrend, from one that was unsustainable, to one that is much more reasonable. But while such a change of pace may seem reasonable in hindsight, to traders in the market at the time of the change it may seem ominous.
When traders become accustomed to long-lasting rallies, a pause in the rally can spark fear. Fear is dangerous because it can cause unexpected sell-offs. Take a market accustomed to rallies and mix in a few bad days or weeks in which prices fail to bounce back, and all of the ingredients are in place for a correction. While the ingredients are not there at the moment, traders should pay close attention to the 1610 and 1621 levels of the S&P over the next week or two weeks, respectively. An S&P below those levels does not guarantee a subsequent correction, but it does make the ingredients available should sufficient economic news become available to act as a catalyst.
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.
• "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.
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.
Long Straddle trading and Long Strangle trading became profitable on March 1, 2013. Since then, each trading strategy has continued to profit, and has reached historically rare levels of profitability on several occasions.
Perhaps more important than the recent high levels of the LSSI is the longevity of the elevated levels. At 15 weeks and counting, from the time the LSSI turned positive, the current streak is one of the longest of the past 10 years. Those long streaks do not make good company, as they are associated with subsequent losses for the S&P, most notably the bear market of 2008.
There's no way of knowing whether the correlation between a long-term elevation in the LSSI and subsequent stock market sell-offs is useful for predicting future sell-offs, but the relationship is worth noting.
A possible explanation for the difference in magnitude of corrections, between those that occur after a briefly elevated LSSI and a long-term elevation, is that the market behaves somewhat like a child. When an elevated LSSI shows a market that is behaving out of bounds, swift non-severe discipline often brings the market back into compliance without much trouble. A market that has been out of bounds for an extended time tends to become bolder, sometimes flaunting its non-compliance openly. In such cases, correcting the market may require more severe measures.
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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