Options Mark Several Concerning S&P Levels

By Chris Ebert

Stocks and Options at a Glance

In the previous Update on October 20 it was noted that the stock market was “as bullish as it gets”. Since then, the S&P has climbed to new record highs. Those highs were not unexpected, since the market was under the influence of Bull Market Stage 1 “lottery fever”.

Currently, the stock market is not as bullish as it was back in late October. It is still bullish, but not to the same extent. The market is currently digesting the recent gains in what is known here as Bull Market Stage 2. When the market is digesting gains, the S&P 500 tends to drift sideways, sometimes experiencing minor pullbacks or dips.

As long as there are traders willing to buy each of those dips, the choppy sideways moves can be considered part of healthy digestion. While a market digesting gains is not overly concerning, there are some things for which all traders should be on the lookout. Some simple option strategies can pinpoint those things.

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 SPY

You Are Here – Bull Market Stage 2

During Bull Market Stage 1, just about any bullish option strategy will turn a profit. That includes profits on Covered Calls, Long Calls and Long Straddles. However, when the market begins digesting gains, Long Straddles are the first of those three strategies to lose profitability. Long Straddles are very expensive option trades to open, so it is no surprise that they are the first to stop generating profits.

This past week saw the market take a pause in what was previously a roaring uptrend. As a result, Long Straddles were unable to turn a profit. That development, in itself, is not a big deal, since the performance of other option strategies indicates that bullishness remains quite strong.

Bullish emotions are evident in the performance of option trades:

Covered Calls (Category A) trades are profitable, as they are in any market except a Bear market.
So, they get a grade of A+
Long Calls (Category B) trades are profitable, as they are in a strong Bull market.
So, they get a grade of B+.
Long Straddles (Category C) trades are losers, which is common in all but the strongest trends.
So, they get a grade of C-.

The combined grade of the 3 strategies is currently A+ B+ C-, which is the definition of Bull Market Stage 2. For a complete description of all Option Market Stages click here.

What Happens Next?

For now, there is no concern that the current Bull market will not continue for the remainder of 2013 as it has done for all of 2013 so far. But, nobody can predict the future. So what is important is to take note of what would raise concerns. A very simple way is to consider how certain option strategies would perform in the future if certain events affect the S&P 500.

For example, if the S&P falls below the 1730-1740 range during the month of November, that would cause Long Calls to become unprofitable, indicating a significant loss of Bullish strength and confidence, what is known here as Bull Market Stage 3. Loss of confidence can be temporary, so it is not usually a major concern, but it is an important warning for those with long stock positions to pay close attention. Stage 3 is depicted on the following chart as being bounded by the orange and yellow lines.

If the S&P falls to the 1680-1690 range during November, that would cause Long Straddle trades to experience a loss of 6% or more, indicating that the market is poised to make a major breakout from its current trading range. An upcoming breakout is a serious concern because it often occurs quickly, and can either propel the S&P to new highs or else send it tumbling into a correction. The orange line on the above chart depicts the danger zone at which the S&P either bounces up into a much higher trading range, or else experiences a major Bull market correction. A healthy correction would be expected to cause the S&P trading range to be between red and orange lines that bound Stage 4. As long as the S&P stays above the red line, there is no reason to suspect that stocks are experiencing anything worse than a healthy correction.

If the S&P falls below the 1640-1650 range during November, that would cause Covered Call trading to become unprofitable. Since that is something that rarely occurs outside of a Bear market, such a development should raise considerable concerns over the health of the current Bull market. On the above chart, the red line depicts the dividing line between a Bull market and a Bear market. Below the red line it is likely that the market has entered Bear Market Stage 5.

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 past 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 1645 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.

Long Call trading has been profitable for most of 2013 except for a brief break from August through early October. The break in that historically long streak of profitability marked an important shift in bullish confidence; the Bulls lost the strength they had earlier in the year. This was evident in the recent failed attempt to break the 1710 weekly-close record on the S&P. The Bulls have since gained confidence, as revealed by the return of profits on Long Call trading, which allowed the S&P to set new record highs. Only if the S&P closes the upcoming week below 1739 will Long Calls 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.

The LSSI currently stands at -1.1%, which is normal. Such levels suggest that option traders have had a good handle on predicting the future. Excessive profits, such as those exceeding 4%, will not occur this coming week unless the S&P exceeds 1853. Anything higher than that is likely to result in some selling pressure, and historically has been associated with Bull-market corrections. Excessive losses, such as those exceeding 6% will not occur this coming week unless the S&P falls to 1684. At or near that level a 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.

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!”