By Chris Ebert
Stocks and Options at a Glance
When stocks prices break out to new highs, it is not surprising to those who study the performance of stock options. Long Straddle and Long Strangle option trades have a great track record of predicting when a breakout is likely to occur. The Long Straddle/Strangle Index (LSSI), which is published here weekly, follows the performance of these option trades on the S&P 500 stock index. When the LSSI gets abnormally low, near -6% or so, as it has been for several weeks, the S&P almost always breaks out into a new trading range.
The stock market has been in somewhat of a correction for several months now, as prices moved sideways in the 1600 - 1700 range. A Bull market undergoing a correction is known here as Bull Market Stage 4. In order for Stage 4 to come to an end, the S&P must break out into new highs above the 1700 level.
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 4
A roaring Bull market, such as the one that has dominated most of 2013 must eventually experience a correction. That correction can occur the traditional way, by a sharp decline of 10% or so off of the highs. Or, it can occur with an extended period of several months in which prices move sideways. The current correction is the latter.
Preparing for What Will Happen Next
The S&P has moved sideways since May; and that's an awfully long time for the Bulls and Bears to stand off without a clear winner. As was mentioned here for the past several weeks, a trendless market cannot last long. When there has been no trend for several months, any catalyst can act on traders' emotions to bring about a new trend - either a reversal of the current trend, or a massive move that confirms the current trend.
The S&P set record highs in August near the 1710 level as the market was undergoing "lottery fever" in Bull Market Stage 1. That level is now of critical importance. If the S&P is able to rally above 1710 and hold its place there, the current Bull market correction is likely over and prices could skyrocket into the 1800s. But, if that 1710 level cannot be maintained, the correction could become much deeper.
To summarize the Options Market Stages for the upcoming week ending September 21, 2013:
- S&P over 1747 indicates a return to Stage 1 lottery fever.
- S&P between 1689 and 1747 indicates a return to Stage 2 digesting gains.
- S&P between 1650 and 1689 indicates a return to Stage 3 resistance.
- S&P between 1572 and 1650 indicates a Stage 4 correction is underway.
- S&P under 1572 indicates the presence of a Stage 5 Bear Market.
- S&P bouncing off 1572 is a strong Bull Market Stage 5 all clear signal.
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. In fact, Covered Call trading became profitable in late 2011 and has remained profitable every week since then except for two very minor losses. That means the Bulls have been in control since late 2011 and remain in control today. As long as the S&P remains above 1572 over the upcoming week, the Bulls will 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.
Three weeks ago, Long Call trading and Married Put trading both became unprofitable for the first time since February 1, 2013. The break in that historically long streak of profitability marks an important shift in bullish confidence. Only if the S&P closes the upcoming week above 1689 will the Bulls will regain 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 -3.9%, which is historically quite low. Such levels often precede a breakout of the S&P into a new trading range. When such a level is reached in a longer-term Bull market, such as the current one, it can mark an important turning point. Either stock prices break out higher, ending the pullback, or they break out lower and confirm that a more significant pullback - a correction - is underway. 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.
Updates to the above analysis may be found at @optionscientist
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!"
Related Options Posts: