Options + Fibonacci = Powerful Indicator

By Chris Ebert

During a sell-off in the stock market, in which prices are tumbling, who is it that is buying all the shares of stock that are being sold?

Somebody has to buy each stock, or else there would be no trades. Someone has to take the other side of the trade – which is why the term sell-off can be misleading – there is just as much buying as there is selling during a sell-off.

The term sell-off simply means that sellers have lost control of the price and must accept whatever bid price is offered. Sellers are not in a position to haggle during a sell-off; buyers are.

It is important for a trader to understand the reason that folks are buying stocks during a sell-off, because the folks who are buying stocks will have an effect on stock prices in the future. If the buyers have weak hands, they will readily be shaken out of their positions, leading to a speedy continuation of the downtrend in prices. Strong hands, however, can lead to impressive rallies, even when the overall outlook for stocks may appear weak. Some sell-offs lead to vigorous new growth; others lead to further decay, depending on whether hands are strong or weak.

A common method in widespread use among traders looking to decipher whether stocks are moving to weak hands or strong ones during a sell-off is a Fibonacci analysis. The method has its advantages, but also has a tendency to be a bit abstract. The following analysis of the options market is designed to aid a trader with Fibonacci. To begin, it is important to know exactly what types of option trades are currently profitable on the S&P 500 as a whole.

Click on chart to enlarge

* All profits are calculated at expiration, as a percentage of the underlying SPY share price. SPY is an Exchange Traded Fund (ETF), the SPDR S&P 500 ETF Trust SPY that closely tracks the performance of the S&P 500 stock index. All options are at-the-money (ATM) when-opened 4 months (112 days) to expiration. (e.g. Profit of $6 per share on an expiring Long Call would represent a 3% profit if $SPY was trading at $200, regardless of whether the call premium itself actually increased 50%, 100% or more)

You are here – Bull Market Stage 3 – the “Resistance” 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 October 4, 2014, this is how the trades performed on the S&P 500 index ($SPY or $SPX):

Covered Call and Naked Put trading are each currently profitable (A+).
This week's profit was +2.7%.
Long Call and Married Put trading are each currently not profitable (B-).
This week's loss was -1.1%.
Long Straddle and Strangle trading is currently not profitable (C-).
This week's loss was -3.8%.

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 3, known here as the resistance stage. This stage gets its name from the tendency for stocks to experience strong resistance if they approach recent highs.

Stage 3 often behaves as if traders have become spooked by bullish weakness and therefore have developed a propensity to sell the rip as if each rally is a surprise gift – an opportunity to bail out of remaining long stock positions on a high. It is a stark contrast to the buy the dip mentality of Stage 2 in which each dip was seen as gift for those looking to enter new long stock positions on a low; and an even greater contrast to Stage 1, in which there were few if any dips to speak of.

A chart describing all of the different Options Market Stages is available by clicking the link at the left.

Fibonacci and Stock Prices

The basic theory behind a Fibonacci type of stock market analysis is that anything that grows exhibits a natural process of branching. Thus the stock market, since it grows, can be considered to branch at predictable intervals, much like a tree grows branches or a person grows limbs.

Without going into too much detail, Fibonacci simply predicts branching to occur whenever something grows to be 1.618 times as large as the level of the previous branch. When such branching occurs, the previous branch will be found at 0.618 times the full length of the branch. For example:

if a tree grows 1 meter high before the trunk divides the first time it can be predicted that it will divide again when it reaches 1.618 meters in height.

if a second branch forms at 1.618 meters above the ground, without knowing the height of the first branch it can be predicted that the first branch occurred at 0.618 x 1.618 meters = 1 meter above the ground.

The numbers 1.618 and 0.618 form what is known as a golden ratio, which is indeed found quite often in nature. Since the stock market can be considered a natural process of growth, it is not inconceivable that the golden ratio may be found in stock prices.

Evidence of the golden ratio has been reinforced over the years, by folks who use this ratio as a basis for trades, thus the existence of the golden ratio in stock prices may be man-made, having been artificially created by traders, or it may exist naturally; there is an argument for each. Either way, it does exist, at least to some degree, and does have an effect on stock prices.

In its most basic form, a simplified example of the golden ratio for stock prices might be a stock that has grown by $100 per share since it's last major pullback. The stock would be expected to either form a new branch or else stop growing at 1.618 times the amount of growth, or $161.80 growth per share. $161.80 of growth, above the price of the previous low, would be seen as a level of strong resistance for a Fibonacci trader.

As another example, if a trader knew that the current stock price had grown $100 per share off a previous low before hitting major resistance, that the stock must have formed a branch when it had grown $61.80, whether that branch was visible or not. Thus, a Fibonacci trader would predict that the branch (at $61.80 over the previous low) would remain even if all the growth above $61.80 was removed during a sell-off.

If a sell-off was to remove any previous growth below that $61.80 level, it would be an indication that the stock itself was unhealthy.

Fibonacci analysis often assumes that healthy stocks grow, one section at a time, each new section being 0.618 times the size of the previous section; and any two consecutive sections, combined, are 1.618 times the size of the larger section. When a healthy stock adds new growth, it will hit resistance when the 1.618 ratio is reached. When a healthy stock withers a little, it will not lose more than it's last section of growth, and will therefore find support when the 0.618 ratio is reached. Anything above 1.618 or below 0.618 suggests either something fundamental has changed or that the analysis was not performed properly.

Options and Fibonacci

As presented above, one of the many uses of Fibonacci analysis is in determining where the most recent section of growth lies. If something withers harmlessly, such as a tree losing its summer growth during the winter months, the most recent growth falls away, but nothing more. If something more sinister is going on, for example if the tree has become diseased, more than just the recent growth may be damaged.

When it comes to the stock market, natural pruning is healthy. When a Bull market corrects, it can provide a widely accepted level of support for all traders – the lowest price represents strong support. Traders are able to place more capital into stocks when support is well known, because they are able to clearly define their risk. As long as the market remains healthy, stock prices should not fall below the pre-determined support – the lowest low.

More traders taking more risk can be the ingredients for a snap-back rally after a sell-off. The stronger the support, the greater the risk traders are willing to take, and the stronger the resulting bounce in stock prices.

The strongest support of all, therefore, would be expected to exist when stock prices have withered back as far as possible without causing harm. At such a level, there would exist zero downside risk (provided the market is indeed healthy) while upside potential would be virtually unlimited. It is no surprise, therefore, that some of the biggest rallies of all come right after the stock market has tested the borderline between a Bull market and a Bear market. That's the lowest low, without signaling something more sinister.

If stock prices fall as far as they can fall, without causing a Bear market, then traders are free to enter stocks with virtually zero risk. For Fibonacci, a decline of 0.618% of the recent growth would represent the lowest low. The only problem – what exactly constitutes recent growth?

Recent growth could constitute different things depending on a trader's time frame. For example, the S&P 500's move from its low near 700 a few years ago to it's high near 2000 this year represents a huge segment of growth. When looking at such a large time frame, the 1300 point growth in the S&P would require a pullback of 800 points (0.618 x 1300) in order to satisfy a Fibonacci 61.8% retracement. That means, the S&P could pull all the way back to 1200 and still be considered healthy over the long term.

The result is much different if one uses a shorter time frame. For example the S&P's recent high near 2000 was about 250 points off the low of January 2014. A 61.8% retracement of that 250 point gain would be approximately 150 points, meaning a pullback to 1850 or so would be healthy and anything below 1850 would be more sinister. As with any Fibonacci analysis, the result depends on the chosen time frame.

Choosing the wrong time frame can cause the results to be meaningless, especially if the time frame does not match a trader's holding period for trades. It may be helpful for a trader to consider an alternative definition of a Bear market, to compare it with the results of a Fibonacci analysis. If the two results tend to agree, it may give a trader a higher degree of confidence that the result is meaningful.

One of the simplest definitions of a Bear market is that losses occur on at-the-money Covered Call options opened at-the-money (ATM), and also Naked Put options opened ATM, when those options expire. Covered Calls and Naked Puts only lose in a Bear market.

The expiration date is important, but not nearly as important as it might appear initially. Shorter expirations provide less premium but also less time for stock prices to fall. Longer expirations provide more premium but more time for prices to fall. Except for very short expirations (1-week away) or very long expirations (1-year away) the effect of the expiration date isn't huge. For most expirations, from 1-month to several months away, if an ATM Covered Call or Naked Put results in a loss, a Bear market is underway.

If a Bear market is underway, it stands to reason that stock prices would have fallen below a 61.8% Fibonacci retracement. Thus, if the dividing line is known between a Bear and Bull market, as defined by the profit/loss line of Covered Calls or Naked Puts (as shown by the red line in the chart above), such a line represents a branching point for the stock. Working backwards, if the branching point is known, multiplying that point by 1.618 should yield the point of maximum growth that the stock reached before it began to wither.

The maximum point is easy to find. That's simply the highest high, such at the recent all-time high at the 2019 level for the S&P 500. The point that currently divides a Bear market from a Bull market – the current level which divides profitable ATM Covered Calls from the unprofitable – is indicated by the current level of the red line in the chart above, which is 1916 for the S&P here in early October 2014.

If the recent high of 2019 indicates maximum growth of the current branch for the S&P, and a low of 1916 would represent the maximum level of withering currently possible without representing something sinister, then the most recent branch is 103 points long. The current branch, according to Fibonacci, should be 1.618 times as long as the combination of the current branch and the next most recent branch.. The result, 1.618 x 103 = 167 points.

The most recent branch would have had to begin 167 points below the recent all-time high. That would put the next most recent branch at approximately 1852.

Does 1852 make sense as a point at which the S&P 500 began a new section of growth? It is left to the reader to determine. The 1852 level may have no meaning, or it may have great meaning, depending on a trader's perspective. If S&P 1852 is indeed meaningful, then the dividing line between Bull and Bear, as indicated by the profitability of Covered Call options, also has meaning.

The current level that defines a Bear market, S&P 1916 according to the options analysis, makes perfect sense as a 61.8% retracement off the recent all-time high of S&P 2019 since the distance from 1916 to 2019 is 61.8% of the distance from 1852 to 2019.

Therefore, if S&P 1852 is a meaningful level of branching (either as support or resistance) for a reader, the options analysis lends credibility to the Fibonacci analysis, and the Fibonacci analysis lends credibility to the options analysis. If, however, S&P 1852 is not meaningful to the reader, then the reader may need to seriously consider whether the options analysis or the Fibonacci analysis currently provide any meaningful information at all.

Generally a specific level will have significant meaning if it represented a major low or major high point for the market, or if it once stood as a brick wall of either resistance or support for the S&P.

The options will not always agree with Fibonacci, and even when the two agree, such agreement is up for debate. But, when they do agree, the combination can be powerful. If S&P 1852 is meaningful, and the recent all-time high of 2019 is also meaningful, then a 61.8 Fibonacci retracement to 1916 would be especially significant since it agrees with this week's options definition of the absolute bottom if the current Bull market is to continue. Thus, S&P 1916, if it was to occur this week, would either signal the beginning of a major growth spurt or it would signal the presence of serious disease for the Bull market.

For a more in-depth look at the option strategies used in the above analysis, the following weekly 3-step analysis as provided.

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 1916 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 1916 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.

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

Losses on Long Call trading occurred this past week for the first time in several months. 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. But the winning streak ended in mid-September. 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 2010, Long Calls (and Married Puts) will remain profitable, suggesting the Bulls retain confidence and strength. Below 2010, 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 -3.8%, 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. Negative values for the LSSI represent losses for Long Straddle option trades. Small losses are quite normal and usual for Long Straddle trading.

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 2057. Values above S&P 2057 would suggest a continuation of 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 2135 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 1939 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 1939 would be a major bullish “buy the dip” signal, while a break below 1939 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