By Chris Ebert
Stocks and Options at a Glance
Some stock market conditions are conducive to certain types of option trades, while other market conditions are detrimental. For example, Covered Call trading tends to be profitable in a Bull market, while it is usually not a good strategy for a Bear market.
Other types of trades depend not only on whether the overall trend is up or down, but also the speed of the trend. Long call trading is a bullish strategy, but it can return losses in an uptrend if stock prices rise at a rate that is too slow. Long Straddle trading can also be employed as a bullish strategy, but it too will return losses when stock prices rise unless the rate of increase is super-fast.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)
Historically, the stock market has tended to progress throughstages in which those three strategies - Covered Call, Long Call and Long Straddle trading - become profitable and unprofitable in a predictable order.
- In a roaring Bull market, Covered Call trading, Long Call trading and Long Straddle trading are all profitable. That type of market is labeled here as Bull Market Stage 1 - the "lottery fever" stage.
- When a Bull market starts to lose some momentum and prices move sideways or become range bound for several weeks, Long Straddle trading is the first of the three strategies to become unprofitable. That type of market is labeled Bull Market Stage 2 - the "digesting gains" stage.
- When a Bull market experiences an extended period of sideways trading or a pullback on the order of 5% or so off of its highs, Long Call trading tends to join Long Straddle trading as a losing strategy. That type of market is known as Bull Market Stage 3 - the "resistance" stage.
- When a Bull market experiences several months of small pullbacks or a correction of 10% or so off of its highs, all three strategies become unprofitable; Covered Call trading, Long Call trading as well as Long Straddle trading. That type of market is known as Bull Market Stage 4 - the "correction" stage.
While the market has historically progressed somewhat predictably from Stage 1 to Stage 2 and later to Stage 3 and then 4, there have been a few occasions when it did not. For example, it has at times gone from Stage 1 to 2 and then reverted back to Stage 1 again. Although a reversion is a relatively rare occurrence, it is useful to note that it is not impossible.
You Are Here - Bull Market Stage 2
We are currently in Stage 2 which began a few weeks ago on June 22 when Long Straddle trading became unprofitable. A progression to Stage 3 would occur if the S&P was to close below 1604 this Friday (July 12) because that is the point at which Long Call trading would become unprofitable. Although historically unlikely, a close above 1650 would mark a rare reversion to Stage 1 because that is the point at which Long Straddle trading would return to profitability.
- If the S&P ends this week between 1604 and 1650 Stage 2 will continue.
- If the S&P ends this week below 1604, we would progress to Stage 3.
- If the S&P ends this week above 1650, we would revert to Stage 1.
Reversions to previous stages have not occurred often enough, at least not in the past 10 years, to provide a large enough sample size to produce reliable insight. Still, it is interesting to note how the market has behaved in the past, in the days and weeks following such a reversion.
- 2005 - The market was at Stage 1 at the end of 2004 into the first weeks of January 2005 with the S&P topping the 1200 mark. A pullback in mid-January brought on Stage 2. But just when the market was teetering on the brink of Stage 3, it instead reverted to Stage 1. The end result was not for a long-term continuation of the Bull market but for a retest of the 1200 mark in March in what turned out to be a double top which preceded a sell-off of 7% by April.
- 2007 - The market was roaring higher toward S&P 1500 in Stage 1 at the end of 2006 into February 2007. A sudden pullback brought on Stage 2 and then Stage 3 during March 2007 only for it to revert to Stage 1 by April. Subsequently it went on to retest 1500 in early July forming a double top that preceded a 7% sell off later that month which turned out to be the beginning of the 2008 Bear market.
- 2012 - The S&P was roaring back above 1300 in January 2012 in a well-defined Stage 1, but after a few weeks of trading sideways it had entered Stage 2 and was on the brink of entering Stage 3 by mid-February. But instead of Stage 3, a reversion to Stage 1 saw the S&P exceed 1400 by March. That level was short-lived though, as a significant 10% correction quickly ensued, bringing the index below 1300 by the end of May.
Although the evidence is anecdotal at best, it would seem that reversions to Stage 1 may be associated with temporary strength in the stock market, as opposed to the reversion representing an end of temporary weakness. If such a hypothesis was true, a reversion of the current market to Stage 1 might also be associated with a temporary return of the go-go days of earlier this year.
A reversion to Stage 1, which would occur if the S&P ends this week above 1650, could conceivably be interpreted as an indicator that the market had a high probability of temporarily retesting the recent record highs, perhaps surpassing those highs slightly, before finally experiencing a true correction; one in which major indices such as the Dow, Nasdaq and S&P are off their highs by 10% or more. Confidence in such a prediction is quite low though, as reversions are rare and thus do not provide a sufficient amount of data to test any correlation between reversions and temporary stock market strength.
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, which is somewhat surprising as the trend for these types of trades has been clearly headed toward unprofitability. Although historically uncommon, the profits "bounced" almost exactly off of the line dividing profitability from unprofitability. Such a bounce is analogous to a second wind for the Bulls. It brings up a very real possibility that the Bulls may get a chance to retest the market's recent record highs. If the S&P closes this week below 1604 it will end the profitability of Long Call trading and signal a significant loss of strength for the Bulls. Anything over 1604 gives the Bulls 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.
Long Straddle trading and Long Strangle trading became profitable on March 1, 2013. That marked the beginning of a surprising uptrend in stock prices. The profits continued uninterrupted for 16 weeks, the second longest winning streak in the past 10 years before finally returning to losses a few weeks ago, on June 22.
If the S&P remains below 1650 this week, Long Straddle trading will remain unprofitable. A level above 1650 would represent a relatively rare reversion to profitability. Although the data is scarce, such reversions have been associated with double tops in the past, and these short-lived rallies tended to end with a significant correction.
While the recent pullback in stock prices does not yet meet the criteria of a typical Bull market correction, it is quite possible that a correction may still occur. 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 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.
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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