Beware – Options Rank S&P Rally C-Minus

By Chris Ebert

When the Dow and S&P 500 set new record highs a few weeks ago, those highs were soon followed by even more record highs. Since new records were just set again this past week, some may wonder whether now might again be a good time to buy stocks. But, there is more to the story than just record highs.

After all, it may be helpful to consider the following:

If every record high marked a good time to enter the stock market, stock prices would never fall, they would just keep climbing, continuously setting new record highs, because each subsequent record would encourage more buyers to buy while deterring sellers from selling.

Not surprisingly, record highs often coincide with the release of great economic news, for example, last week's remarks by Fed chair Janet Yellen. However, despite the push higher from last week's news, the market is not screaming “overbought”, at least not from the standpoint of the following analysis of stock options on the S&P 500.

A stock market setting new highs, at the same time that there are few indications of widespread overbought conditions, might seem like an ideal time to buy stocks. But, traders might want to think twice, because sometimes “overbought” conditions are actually preferable, particularly when new highs are involved.

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

Consider this – Do you want to buy stocks because they are setting surprising new highs that are making even the most bullish Bulls shake their heads in disbelief? Or, do you want to buy stocks when widely-perceived-as-superb economic news, which you would probably expect to result in higher stock prices anyway, indeed results in new highs but fails to surprise anybody?

Euphoria, or as it's called here – Lottery Fever – can cause a lot of head shaking. But all of that head shaking can be a sign that traders are considering jumping into stocks despite perceptions that they are overbought. Meanwhile, a strong rally, if the rally itself seems rational, in-line with the gravity of the news, decidedly not euphoric, and also not similar to the feverish buying of lottery tickets surrounding some record-setting lottery jackpots, can leave traders feeling like they missed out.

The fear of buying too late is very real; and that fear feeds on predictability more so than euphoria, which by definition is irrational and therefore unpredictable.

In the absence of Lottery Fever, in the absence of an irrational euphoric buying frenzy, a strong rally, even one that sets record highs, can quickly deplete the number of new buyers, at least temporarily, sometimes leading to a pullback off of the highs. Therefore it is important to note that Lottery Fever is currently absent from the stock market.

You are here – Bull Market Stage 2 – the “digesting gains” Stage.

On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending June 21, 2014, this is how the trades performed:

Covered Call trading is currently profitable (A+). This week's profit was +3.1%.
Long Call trading is currently profitable (B+). This week's profit was +2.5%.
Long Straddle trading is currently not profitable (C-). This week's loss was -0.6%.

Click on chart to enlarge

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 2, known here as the “digesting gains” stage. It is so named because it often encompasses a period of consolidation (digestion) which follows a significant rally and often precedes the next leg up for stock prices in general.

Bull Market Stage 2 is a relatively rational stage when compared to the irrational euphoria of the “lottery fever” of Bull Market Stage 1.

For a description of Stage 2, as well as a comparison to all of the other stages, see the chart on the left (click to enlarge):

What Happens Next?

It's very simple this week. Traders will in the coming days realize Yellen's recent remarks have run their course, as far as inducing a rally in stock prices. Unless some new economic news suddenly overshadows the Yellen news, if the rally is still in progress when they come to that realization, there will be a tendency for them to believe the market has become “overbought”.

If they believe the market is overbought, yet under the influence of “lottery fever”, many will likely chose to ride the trend higher rather than try to force their own views on the market. It is often difficult to sit out a rally on the sidelines, or worse yet, to short it, no matter how seemingly irrational the rally, because the market can remain irrational much longer than the average trader can remain solvent.

If they instead see an overbought market acting rationally, they may tend to do the rational thing – take profits, wait before entering new longs, or tighten stops – any of which could fuel a pullback in stock prices.

Lottery fever is apparent when Long Straddles (category C trades shown above) are profitable, since a Long Straddle is a trade that is structured to perform well when a rally becomes surprisingly strong, even to option traders who as a group are devoted to avoiding surprises. Thus, C+ indicates lottery fever and C- indicates a lack of it.

A rally with a grade of C- therefore presents a specific risk, because it suggests traders have not reacted to news in a surprisingly irrational manner, but a predictable rational manner – a rational manner that may make it easier for some folks to call a top, since they may expect the top to occur in a predictable, rational spot. It is not of great importance that these top-callers be correct, only that the environment, specifically a lack of irrationality or a lack of lottery fever, makes folks confident in their ability to call a top.

All it takes is confidence, because if enough top-callers react, their reaction can become a self-fulfilling prophesy, in which the top-callers actually cause the market to put in a top.

So, it is important to be able to recognize the level of the S&P that would represent irrational “lottery fever” this week and a level that would suggest a more rational market that is simply “digesting gains”. On the chart above, it can be seen that 1995 to 2070 indicates “lottery fever” this coming week. Thus, if the Yellen rally, or any subsequent news-driven rally pushes the S&P above 1995 this week, it might behoove traders to join the rally, no matter how overbought and irrational it might seem.

On the other hand, in the absence of lottery fever, if the S&P remains below 1995 this week, there is a chance the current Yellen rally could run out of steam; and if there is not enough new good news to pump in some new steam, it could result in a pullback off the recent record highs while the market fully digests its recent gains.

If such a pullback was to ensue, it may prove helpful to note that there is a possibility that a significant recent high at the 1950 level (significant because it acted as a resistance level for several days) may not act as the strong support that sometimes occurs at old resistance levels. Strong resistance, often called brick-wall resistance, was not seen when the S&P recently pushed above 1950.

Since there was no brick wall on the way up, it is quite possible there would be no brick wall on the way down either, should the market head in that direction.

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.

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 1820 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 1820 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.

Long Call trading became unprofitable this past March, Those losses intensified during April and early May before reverting back to profits in recent weeks. 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 1936, Long Calls (and Married Puts) will remain profitable, suggesting the Bulls retain confidence and strength. Below 1936, 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. Most important is the profitability of these trades opened 112 days prior to expiration.

The LSSI currently stands at -1.2%, 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 1995. Above S&P 1995 would suggest a significant shift in sentiment, back to a 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 2070 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 1882 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 1882 would be a major bullish “buy the dip” signal, while a break below 1882 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