Proof That Markets Can Still Move Higher

By Chris Ebert

Option Index Summary

Proof is a strong word when it is applied to the stock market. Technically the only true means of proof comes from hindsight. But there are proven methods of analyzing the stock market that reveal telltale signs about what the market is going to do next.

This week, those signs are saying the market still has room to go higher. That may be difficult to believe given that major indexes such as the Dow and the S&P are up over 5% so far in 2013, and it's only January. The pace is unsustainable for sure – the current economy just is not the type that lends itself to 50% annual returns.

If stock prices continue to climb at the current rate, they will eventually reach a point where profit-taking becomes widespread. In other words, the market will experience a sell-off, not necessarily due to economic news, but a sell-off for sell-off's sake – what many call a healthy correction. Traders can only take so much of a good thing. So when the Bulls drive prices too high, too fast, many traders get spooked. That leads them to take their profits off the table. Their emotions take over and their fear of a sell-off actually sparks a sell-off.

Learning when traders are likely to feel an emotional need to take profits can be done by analyzing some simple option trades in a three-step process:

STEP 1: Are the Bulls in control of the market?

The performance of Covered Calls and Naked Puts 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.

STEP 2: How strong are the Bulls?

The performance of Long Calls and Married Puts reveals whether bullish trader's 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. It's been several weeks since these trades returned profits, so this week marks an important change. It means the Bulls are not only in control now, but they are confident and strong. 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, but they are 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 overstepped their authority?

The performance of Long Straddles and Strangles 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.

This week, long straddle trading and long strangle trading were both unprofitable. That means the Bulls have not yet overstepped their authority. While they have pushed the market significantly higher so far in 2013, and while the pace of the current uptrend is unsustainable if it continues much longer, they have not yet pushed too far. There is still room for the market to move higher before it will become due for a correction. 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 only been going up quickly, but have gone up surprisingly fast.” Profits warrant concern that the market may be becoming over-extended, 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 uptrend has been ridiculous and unsustainable.” No matter how much strength the Bulls have, they have pushed the market too far, too fast, and it needs to correct

Conclusion

The bulls retained control of the market this week. They also gained strength this week, but not so much that they are overstepping their authority. The market still has room to move higher. While there is no guarantee that it will indeed move higher, it has not yet reached a level where a correction becomes a necessity. A correction may occur for other reasons though, such as unexpected economic news. But for now, Dow 14,000 and the S&P 1500 is in and of itself not a major concern. Dow 14,500 or S&P 1550; that's a different story altogether.

Option position returns are extrapolated from historical data that, while reliable, cannot be guaranteed accurate. It is not possible to match the exact performances shown, because the strike prices and expiration dates used in the calculations will not always be available in actual trading. All data is relative to the S&P 500 index.

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!”