2013: What A Year For Option Straddle Trading!

By Chris Ebert

Stocks and Options at a Glance

This past week's stock market rally was not surprising. That's because a specific type of option trade known as a “Straddle” is currently profitable. When Long Straddle* trading is profitable in a Bull market, the market tends to rally; and such rallies tend to take place regardless of good or bad economic news. Fittingly, this type of market is labeled below as the “lottery fever” stage, also known as Bull Market Stage 1.

Perhaps the disconnect between the stock market and the economy is never more evident than when Long Straddle trading is profitable. Of course there is never any real connection between stocks and the economy – they are two separate entities. But there are times when improving or deteriorating economic conditions affect the outlook of stock traders regarding the future potential for increasing or decreasing corporate sales and profits; and this pushes stock prices higher or lower, respectively. The “lottery fever” stage is generally not one of those times. The economy is now as irrelevant as it gets.

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*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

It is not uncommon for the stock market to become disconnected from the economy. As with any tradable instrument, stocks are prone to cycles of boom and bust that seemingly have little to do with the current condition of the economy. When lottery fever strikes, stocks are in the boom part of the cycle. Booms generally resolve themselves through market corrections. However, when corrections fail to materialize, booms sometimes progress into full-fledged bubbles; and bubbles are more likely to resolve themselves by bursting, also known as a crash.

The longer a boom lasts, the more likely it is to create an unsustainable bubble. By the same reasoning, the longer Long Straddle trading remains profitable, the more severe the sell-off is likely to be when that day arrives (and it will). Long Straddle trading became profitable on March 1, 2013 and except for a short 3-week break in June it has remained profitable for the past 21 weeks. That's quite a long time – 21 weeks of lottery fever and Long Straddle profits without a 10% correction in the S&P – such a long time that the word “bubble” may become more appropriate in coming weeks and months, unless a true 10% correction ensues.

You Are Here – Bull Market Stage 1

The profitability of Long Straddle trading defines Bull Market Stage 1. For the upcoming week (ending July 27) Long Straddle trading will remain profitable as long as the S&P remains above 1648. That is an indication that “lottery fever” will continue if the S&P does not fall below 1648 this week.

The profitability of Long Straddle trading occasionally reaches ridiculous and absurd levels. Often a profit of more than 4% signals an upcoming correction on the order of 10% off recent highs in the S&P. If the S&P was to reach 1710 this week, Long Straddle profits would reach that 4% threshold and would thus signal the possibility of an upcoming correction. Corrections do not always occur immediately after Straddles return 4% profits, but there has been a strong correlation between such profits and subsequent corrections over the past 10 years.

The loss of profitability of Long Straddle trading defines Bull Market Stage 2 – the “digesting gains” stage. For the upcoming week, Long Straddle trading will become unprofitable if the S&P falls below 1648, so 1647 would mark the beginning of Stage 2.

The loss of profitability of Long Call trading defines Bull Market Stage 3 – the “resistance” stage. For the upcoming week, Long Call trading will become unprofitable if the S&P falls below 1600, so 1599 would mark the beginning of Stage 3.

The loss of profitability of Covered Call trading defines Bull Market Stage 4 – the “correction” stage. For the upcoming week, Covered Call trading will become unprofitable if the S&P falls below 1505, so 1504 would mark the beginning of Stage 4.

The resumption of profitability of Covered Call trading defines Bull Market Stage 5 – the “all clear” stage. For the upcoming week, a bounce higher from S&P 1504 would be a strong indication that the market had reached the bottom of a Bull market correction.

The realization of large losses on Covered Call trading defines Bear Market Stage 5 – the “Oh No!” stage. For the upcoming week, a loss of support at S&P 1504 would be a strong indication that the S&P was more likely entering a Bear market than it was to be experiencing a simple Bull market correction.

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To summarize the upcoming week ending July 27, 2013:

S&P > 1710 at Friday's close signals extreme “lottery fever” and a possible upcoming correction.
S&P between 1648 and 1710 signals continuing “lottery fever”.
S&P between 1600 and 1647 signals a market “digesting gains”.
S&P between 1505 and 1599 signals that recent highs have now become strong “resistance”.
S&P bouncing higher from 1504 signals the end of a “correction”.
S&P falling below 1504 signals “Oh No!” this is not a correction, it is a Bear market.

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 1505 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.

This week, Long Call trading and Married Put trading were both profitable, which is somewhat surprising as the trend for these types of trades has been clearly headed toward unprofitability. Although historically uncommon, the profits “bounced” almost exactly off of the line dividing profitability from unprofitability. Such a bounce is analogous to a second wind for the Bulls. It brings up a very real possibility that the Bulls may get a chance to retest the market's recent record highs and possibly surpass them. As long as the S&P closes the upcoming week above 1600, the Bulls will retain 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.

Long Straddle trading and Long Strangle trading became profitable on March 1, 2013. That marked the beginning of a surprising uptrend in stock prices. The profits continued uninterrupted for 16 weeks, the second longest winning streak in the past 10 years before finally returning to losses a few weeks ago, on June 22.

Long Straddle trading returned to profitability on July 19, 2013; a relatively rare event given that either a correction on the order of 10% or so, or several months of sideways digestion often occurs between streaks of profitability for Long Straddles, neither of which was present this time. Although the data is scarce, such reversions have been associated with double tops in the past, and these short-lived rallies tended to end with a significant correction.

While the recent pullback in stock prices does not yet meet the criteria of a typical Bull market correction, it is quite possible that a correction may still occur. A level of the S&P above 1710 this coming week would push the LSSI over 4% signaling that the market was “Due for a Correction”. An elevated LSSI has always led to a correction in the past, and there's no reason to suspect this time will be an exception. It's just a matter of how long until it occurs. 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.

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!”