Stock Options Explain Doji Candles

By Chris Ebert

Candlesticks are a common tool that some stock market traders use to gauge sentiment and emotions in the market. Since emotions affect the reactions of traders, the reactions of those traders can reveal their emotions; and knowing those emotions can give a trader an edge.

Traders who are aware of the predominant emotions in the market can make educated guesses about how the market will perform in the future, albeit not with 100% accuracy, but with enough accuracy to be helpful.

Candlesticks can help traders detect emotions. Understanding those emotions, however, can be confusing. In order to dispel some of the confusion, an analysis of stock options can shed some light on emotions, thereby making candlesticks easier to decipher.

To begin an analysis of stock options covering a broad basket of stocks, it is important to know which types of specific option trades are currently profitable on the S&P 500 as a whole.

*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 1 – the “lottery fever” Stage.

Click on chart to enlarge

On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending July 26, 2014, this is how the trades performed:

Covered Call and Naked Put trading are each currently profitable (A+).
This week's profit was +3.1%.
Long Call and Married Put trading are each currently profitable (B+).
This week's profit was +3.0%.
Long Straddle and Strangle trading is currently profitable (C+).
This week's profit was +0.0%.

* All profits are calculated at expiration, as a percentage of the underlying $SPY share price, using options ATM-when-opened 4 months to expiration (e.g. Profit of $6 per share on a Long Call would represent a 3% profit if $SPY was trading at $200, even if the call premium increased 100%)

Using the chart above, it can be seen that the combination, A+ B+ C+, occurs whenever the stock market environment is at Bull Market Stage 1, known here as the “lottery fever” stage due to its similarity to the euphoric buying of lottery tickets that tends to occur when lottery jackpots are unusually high.

Stage 1 is the most bullish stage the stock market can attain, as is often evident from the relatively minor and short-lived effect of poor economic news, and the tendency for traders to “buy the dip”. Stage 1 is accompanied by lower-than-normal option premiums. The most common measure of low option premiums can be found in the S&P 500 Volatility Index (the “VIX”) which often falls into the teens, sometimes lower, when Bull Market Stage 1 is underway. For a description of Bull Market Stage 1, as well as a comparison to all of the other market stages, see the chart on the left (click to enlarge):

Candlesticks Depict an Imbalance of Power

A candlestick is nothing more than a simple visual aid depicted as a vertical line between the lowest trading price and the highest trading price over a given period of time (known as the “wick” of the candle) and the price of the stock at the beginning (open) and end (close) of that same time period (known as the “body” of the candle).

For example, a stock that opened Monday morning at $100 and moved up to $120 by Friday afternoon, without ever falling below $100 or going over $120, would form a candle with a long body from $100 to $120 with no wick. A stock that opened at $100 and traded as high as $120 before falling back to $100 and then closing at $100 would have virtually no body, just one long wick from $100 to $120.

The body of the candle represents progress, since either the Bulls were able to push the stock higher and keep it there, or the Bears pushed it lower and kept it lower. The body shows which side is winning – Bulls or Bears. The wick, on the other hand, represents the broader overall conflict.

The wick of a candle shows how high the Bulls were able to push a stock price before Bears stepped in and pushed in the other direction, or vice versa. In other words, the wick represents a temporary imbalance in confidence and strength, as if each side is saying “Don't cross this line!”, the line being the end of the wick. The body indicates a shift in the balance of power, as if one side won the battle and planted a flag to mark their territory. Bodies from battles, wicks from wars.

Doji Candles Indicate a Balance of Power

A Doji candlestick is one in which there is a wick but only a very little body, when the stock price ends nearly unchanged after temporary moves in either direction. Doji occur when Bulls and Bears share power nearly equally, with the small body indicative that neither side was able to make any significant permanent progress, with the wick showing that any temporary progress made by one side was quickly defended by the other. But, when the market is clearly bullish, as it has been recently, what are they really fighting about?

Of course, there are always Bears, even in the most bullish of Bull markets. These are the folks that believe current stock prices are unjustifiably high for a variety of reasons. These so-called perma-Bears don't really have a major effect the market though, since they are unlikely to change. Who's going to notice a perma-Bear selling stock, given that such behavior is expected?

What the fight is really, truly about right now, is not whether this is going to be a Bull market, but whether it is going to be an ordinary one, with a methodical grind upwards as gains in stock prices are digested, or one with spectacular, euphoric, almost “lottery fever” types of rallies in stock prices.

Candles, therefore, currently represent the fight between Euphoric Bulls and Ordinary Bulls. The wicks represent the war – the conflict of whether or not irrational euphoria is warranted at the moment ; the bodies represent the battle – determined by which side of the conflict has more power at the moment. Doji, since they have no body to speak of, indicate a unique condition of zero progress. Both sides are equally powerful; but, why?

Line in the Sand, Euphoria vs. Digestion?

One of many possible explanations is that there is no clear argument that supports either side at the moment. The argument for stock prices to grind methodically upward, taking time to digest each consecutive gain, is as strong as the argument for a euphoric rally to test new all-time highs. Quite simply, the market is on the line.

The performance of stock options is often a good indicator of emotions, particularly euphoria. Euphoria commonly accompanies a stock market in which Long Straddle option trades are profitable. The correlation of Long Straddle profits and euphoria occurs because Straddles are designed to return profits from the element of surprise. Thus, ordinary rallies do not produce Straddle profits, but euphoric rallies do, since euphoria causes stock prices to increase at a rate that takes most traders by surprise.

Currently the market is straddling the line, so to speak, between Long Straddle profits and Long Straddle losses. So, in that light it is understandable that the Euphoric Bulls are equally as strong as the Ordinary Bulls. A Doji candle, such as the one that occurred this past week on a weekly chart of the S&P 500, confirms the balance of power, thus confirming a likely reason for the battle, as well as the reason for the war itself. The reason is important, because a Doji without a known cause isn't very useful.

What happens Next?

While Doji tend to occur near the dividing line between Options Market Stages, the opposite is true when the market clearly enters a new Stage. Thus, if the S&P moves clearly into the “lottery fever” of Stage 1, or clearly into the “digesting gains” of Stage 2, the balance of power will likely shift to either the Euphoric Bulls or the Ordinary Bulls, respectively. A shift would be expected to bring some long candles with long bodies, as stock prices make some more-than-just-temporary progress one way or the other, quite the opposite of the indecision near the border of the two Stages that caused the recent Doji.

A possible area of interest through the end of August will be the 1950 – 1980 range, which divides Stage 1 from Stage 2. A Doji that occurs near that range over the next several weeks would serve as a reminder that the current conflict is not between Bulls and Bears, but rather it is between Ordinary Bulls and Euphoric Bulls. Doji at other levels, as always, might have different causes, depending on what two types of emotions are in conflict at those levels.

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, which balances sluggish responses of longer expirations with irrelevant noisy responses of shorter expirations.

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, nearly 3 full years later, in 2014.

As long as the S&P remains above 1748 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. Below S&P 1748 this week, Covered Calls and Naked Puts will not be profitable, and since such trades only produce losses in a Bear market, it would suggest the Bears were in control.

he 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 which balances sluggish responses of longer expirations with irrelevant noisy responses of shorter expirations.

Long Call trading became unprofitable this past March, Those losses intensified during April and early May before reverting back to profits in recent weeks and months. 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.

As long as the S&P closes the upcoming week above 1884, Long Calls (and Married Puts) will remain profitable, suggesting the Bulls retain confidence and strength. Below 1884, Long Calls and Married Puts will not be profitable, which would suggest a significant shift in sentiment, notably a loss of confidence by the Bulls. Confidence and strength show up as a “buy the dip” mentality, while a lack of confidence and strength produces a “sell the rip” sentiment that tends to set recent highs as brick-wall resistance, since each test of that high is perceived as a rip to be sold.

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.

The LSSI currently stands at +0.0%, which is normal, and indicative of a market that is neither in imminent need of correction nor in need of a major breakout from the trading range of the last few months. Positive values for the LSSI represent profits for Long Straddle option trades. Profits represent an unusual condition for Long Straddle trading, one of three unusual conditions that warrant attention.

The 3 unusual conditions for a Long Straddle or Long Strangle trade are:

Any profit
Excessive profit (>4% per 4 months)
Excessive loss (>6% per 4 months)

Long Straddle trading (and Long Strangle trading) will not be profitable during the upcoming week unless the S&P closes above 1952. Values above S&P 1952 would suggest a return to the recent euphoric “lottery fever” type of mentality that tends to lead to a rally for stock prices.

Excessive Long Straddle trading profits (more than 4%) will not occur unless the S&P exceeds 2024 this week, which would suggest absurdity, or out-of-control “lottery fever” and widespread acceptance that stock prices have risen too far too fast for the rate to be sustainable, thus needing to correct in order to return to sustainability.

Excessive Long Straddle losses (more than 6%) will not occur unless the S&P falls to 1843 this week. Since excessive losses tend to coincide with a desire for traders to make stock prices break out, either higher or lower than the boundaries of their recent range, a break higher from 1843 would be a major bullish “buy the dip” signal, while a break below 1864 would signal a full-fledged Bull market correction was 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.

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