Options Validate Simple-Moving-Average Analysis

By Chris Ebert

A simple-moving-average, also known as an s.m.a., can be among the most useful technical tools a trader will ever encounter. S.m.a.'s are often helpful in revealing the type of trading environment – for example, a price that consistently bounces higher from a 50-period simple-moving-average is generally a healthy, bullish sign. On the other hand, a price that falls below a 200sma can be a sign that it is a good time to consider closing longs and start thinking about shorting.

Not only are sma's helpful and easy to use, they are popular too. This is especially true of sma's on a daily chart, in which the periods of the moving averages are measured in days, such as:

10-day sma
50-day sma
100-day sma
200-day sma

While the above examples are only a few of many in use, the popularity of the above moving averages tends to increase their usefulness. That's not to say that something like a 26-day sma is not useful. But, popularity does have some advantages. In some ways similar to a self-fulfilling prophesy, the sheer number of traders using the listed sma's tends to cause an expected reaction when a price touches a particular moving average.

As an example: If a lot of traders set a stop-loss order just below a 200sma, each believing that a price falling below the 200sma is an indication of a loss of an important level of support, a price that does indeed fall below that level may result in a sell-off due to triggering of those stop-loss orders.

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

Finding a moving-average that doesn't move.

Despite the popularity and the usefulness of sma's, they all have one thing in common that can cause headaches for traders – as their name implies, they all do one thing; they move. So, it is not possible to predict exactly where a moving average will be tomorrow, or next week, or anytime in the future. Thus, it is difficult to predict what reaction the market will have if the price reaches a particular level, because it can be difficult to predict how that price will compare to an as-yet unknown sma.

How can one predict if the S&P will break through the 10-day sma next Friday without knowing what the 10-day sma will actually be on that day?

The following analysis attempts to help traders identify levels of the S&P 500 which tend to coincide with particular trading environments. Exposing the current trading environment is the intended goal of analyzing some of the more popular simple moving averages, and also the goal of the following analysis, but the following analysis exhibits a distinct difference – the levels obtained in the following analysis do not change. Since the following levels remain constant, a trader may find them useful for such tasks as setting a stop on a stock, or choosing a strike price for an option, without the movement associated with a moving average.

You are here – Bull Market Stage 2.

On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending April 5, 2014, this is how the trades performed:

Covered Call trading is currently profitable (A+). This week's profit was 3.5%.
Long Call trading is currently profitable (B+). This week's profit was 1.6%.
Long Straddle trading is not currently profitable (C-). This week's loss was -1.9%.

Using the chart above, we can see that the combination, A+ B+ C-, occurs whenever the stock market environment is currently at Bull Market Stage 2. For a description of Stage 2, as well as a comparison to all of the other stages, the following chart is provided:

Click on chart to enlarge

What's next?

The following chart shows the limits of each different Options Market Stage for the next few months. As mentioned earlier, the Options Market Stages differ from simple-moving-averages in that the Options Market Stages will not change.

As an example, the dividing line between Bull Market Stage 4 and Bear Market Stage 5 in early May 2014 is very near the 1800 level on the S&P 500. That level will not change between now and May; it will remain near 1800.

No matter how high or low the S&P goes this April, no matter how much the 200-day sma changes over the next several weeks, the 1800ish level will eventually reveal itself as an important level of support when May arrives. Should the S&P be below 1800 at that time, it would be a bearish signal, while above it would be bullish.

It is entirely possible that by the time May arrives, the 200-day sma on the S&P will have moved to a point near the 1800 level. If so, it would offer some validation as to the validity of that level being a highly-important dividing line.

The same loose correlation tends to exist with other popular sma's and Options Market Stages:

The red line dividing Bull Market Stage 4 and Bear Market Stage 5 tends to correlate with the 200-day sma of the S&P 500.
The orange line separating Bull Market Stage 3 “resistance” from a market undergoing “correction” at Stage 4 tends to correlate with the 100-day sma of the S&P 500.
The yellow line that divides a market that is simply digesting gains at Stage 2 from a market undergoing serious resistance at Stage 3 tends to correlate with the 50-day sma of the S&P 500.
The blue line separating the euphoric lottery-fever environment of Stage 1 from a market that is in the process of digesting gains tends to correlate with the 10-day sma of the S&P 500.

Due to the correlations shown above, traders may find it helpful to substitute the Options Market Stage level for the respective simple-moving-average, especially when considering potential trade set-ups that may trigger in future days and weeks, at which time the use of simple-moving-averages may not be feasible due to the inherent movement in those averages.

Weekly 3-Step Options Analysis:

It is often helpful to see the analysis from a different frame of reference. For a more in-depth examination of the Options Market Stages, the following 3-Step analysis is provided.

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.

Covered Call trading did not experience a single loss in 2013, and the streak endures so far in 2014, continuing a streak of nearly lossless trading extending all the way back to late 2011. That means the Bulls have been in control since late 2011 and remain in control here in 2014. As long as the S&P remains above 1763 over the upcoming week, Covered Call trading (and Naked Put trading) will remain profitable, indicating that the Bulls 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 was profitable for almost all of 2013 and thus far in 2014 except for a brief break from August through early October 2013 and minor losses in March 2014. Losses for Long Calls are a sign of weakness for a Bull market. Such weakness can be dangerous because it lowers the perceived reward potential for stock owners, which makes stocks less attractive, in turn lowering the price stock sellers are able to obtain from buyers.

While Long Call trading was profitable this past week, returning gains of +1.6%, in order to be profitable this coming week the S&P would need to exceed 1873. Failure to close next week above 1873 would be a sign of weakness; and weakness always has the potential of putting downward pressure on stock prices. If the S&P fails to close the upcoming week above 1873, Long Calls (and Married Puts) will 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 -1.9%, which is within normal limits. Profits on Long Straddle trades will not occur this coming week unless the S&P exceeds 1929. Anything higher than 1929 indicates the presence of euphoria, often accompanied by lottery-fever-type bullishness, so the S&P exceeding that level this upcoming week would indicate that Bull market of 2013 was once again underway and the recent pullback was simply a pause in the uptrend. While 1929 is not out of the question this coming week, such a level would represent remarkable gains for the week.

Excessive profits on Long Straddle trades, such as those exceeding 4%, will not occur this coming week unless the S&P rises above 2001. Despite the presence of euphoria if the S&P was to reach that level, anything higher than 2001 this coming week would be absurd and would likely to result in some selling pressure. Historically, such absurd bullishness has been associated with subsequent pullbacks and, occasionally, Bull-market corrections. In any case, 2001 is almost certainly out of reach this coming week.

Excessive losses on Long Straddle trades, such as those exceeding 6% will not occur this coming week unless the S&P falls to 1820. At or near 1820 a subsequent breakout is likely. That level is important to watch, as anything below it, should it occur, is likely to indicate a major Bull-market correction is underway, and the market would be at risk of breaking out into a lower trading range. As mentioned in Step 1, if such a lower trading range was to fall below 1763, it could be a very, very bearish signal, while a bounce higher from the 1863 area would be a strong indicator that the market had put in a bottom at a level of strong support.

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.

The preceding is a post by Christopher Ebert, co-author of the popular option trading book “Show Me Your Options!” He uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. Questions about constructing a specific option trade, or option trading in general, may be entered in the comment section below, or emailed to OptionScientist@zentrader.ca