Rarely is the disconnect between the stock market and the economy more apparent than in an extreme Bull market. There are times when stock prices rise so far, so fast that the trend becomes self-perpetuating, feeding on the greed of traders who don’t want to miss the rally.

When such a self-perpetuating trend takes hold, it often seems as if the only thing driving stock prices is the prices themselves, while fundamental economic changes seem to be ignored. Here, such a trend has been given the name Lottery Fever; and when it infects the stock market it’s almost as if no news – not declining corporate earnings, not declining employment, not even the threat of war – can bring stock prices down.

Because traders become so focused on rising stock prices that little else matters, there are only three ways Lottery Fever can end:

1. Stock prices stop going up (consolidate) long enough to make traders look away from the price long enough question the fundamentals, causing prices to fall
2. Extraordinarily horrific economic developments demand traders’ attention, causing prices to fall
3. Stock prices rise so high, so fast, that the market runs out of buyers, causing prices to fall

When it ends, and it will end – someday – it can quickly take away unrealized profits from those who own stocks, mutual funds, or virtually any long-equity position. The following analysis explores ways traders can take actions now to help ensure that all those unrealized profits don’t slip away when Lottery Fever ends.

Using history as a guide, the end is no more than 4 months away. That doesn’t mean the current Bull market will end, necessarily, rather that euphoria will take a break. Lottery Fever will take a break, even if the Bull market continues, almost certainly before January 2015 is over. Now is the time to prepare.

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 (NYSEARCA: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 1 – the “Lottery Fever” Stage.

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On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending September 6, 2014, this is how the trades performed:

• 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 profitable (B+).
  This week’s profit was +4.2%.
• Long Straddle and Strangle trading is currently profitable (C+).
  This week’s profit was +1.5%.

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. This stage gets its name from the tendency for stocks to experience explosive periods of gains interspersed with few if any pullbacks, as if traders are buying stocks like they are lottery tickets and the jackpots are huge.

It is important to note that lottery fever often cannot be confirmed until it has been in place for at least a week. The S&P indeed closed inside the lottery fever stage this past week, confirming it for a third week in a row.

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

Identifying the End of Lottery Fever

As long as stock prices keep going up, there really isn’t any problem for folks who own stock. When Lottery Fever is in effect, there’s virtually no limit to how high stock prices can climb. The only limit is the speed of the climb (the speed limit is discussed later in this analysis). As long as the speed limit is obeyed, rising stock prices are not too concerning.

The word overbought refers specifically to speed, not height. A stock price can theoretically rise continuously forever, without ever being overbought. Overbought conditions are thus not usually a major concern when Lottery Fever is underway.

What does concern folks who own stocks is that Lottery Fever will end. Although extraordinary news could put an end to it, that only happens rarely. Most often, what causes the fever to end is that stocks simply consolidate too long. The enemy to a stock owner isn’t so much declining stock prices (although that’s what causes the actual account damage), it’s the failure of prices to rise, which leads to an end to Lottery Fever, which in turn leads to falling prices.

In the chart above, it can be seen that the euphoria of Lottery Fever is likely to be widespread when the combination of option trades is A+ B+ C+. Specifically, A+(Long Straddle profits), B+ (Long Call profits) and C+ (Covered Call profits).

Thus, the enemy of Lottery Fever is the loss of that combination. The first trade to lose profitability is always C+ (Long Straddles) because Long Straddles are always the most expensive option trades on the market and thus the most susceptible to a slowing of the uptrend in stock prices which occurs as euphoria decreases.

C+ almost always accompanies euphoria, and C+ is almost always accompanied by euphoria. C-, quite simply, is not. On the chart below, the dividing line between C+ and C- (between euphoria and a lack of euphoria) is depicted by the blue line. The green zone above the blue line is euphoric, the blue zone and all the others are not. Thus, one can estimate quite precisely the level of the S&P 500 that would result in a loss of euphoria – it would occur when the S&P moves below the blue line. The blue line, currently near 2000, rises to over 2100 by year’s end.

Thus, if the S&P moves below 2000 now, for example, or below 2100 in December, euphoria would disappear and stock prices would likely fall, at least temporarily, until they found suitable support. It is important to note that stock prices do not need to fall for euphoria to end, since the S&P 500 can move below the blue line without falling, for example, by consolidating sideways.

Click on chart to enlarge

An expanded 10-year historical chart is now available.

As can be seen on the chart, as long as the S&P 500 remains in the green zone, euphoria is likely to be widespread among traders. As mentioned earlier, euphoria can come to an end if the S&P moves below the blue line, either through an extended period of sideways price consolidation or through a sudden sell-off, as tends to occur when some extraordinarily bad news shocks the market. Euphoria can also, and occasionally does come to an end when the stock market breaks the speed limit.

The green line represents a 4% profit on Long Straddle trades in a 4 month period; and that line has served as the S&P 500's speed limit for decades. Lottery Fever can end rather quickly - within a week or so - if the S&P surpasses the green line, indicating it has exceeded its historical speed limit.

Preparing for the End

There are many methods to avoid the losses (or the loss of unrealized profits) that normally affect stock owners when euphoria disappears. After all, even if such a loss is temporary – even if the Bull market resumes quickly – such a loss can be damaging financially, psychologically or both.

• Method #1 – Sell
  Selling stocks now, near all-time highs, guarantees those unrealized profits will be realized, and thus will not be lost. Of course selling means giving up the chance of more profits, and since stock prices often rise and rise quickly during Lottery Fever, selling is not a very attractive method.
• Method #2 – Buy a Put option
  Buying Put options guarantees the sale price of stocks that are already owned. Accordingly, such options are called Protective Puts. Now is a great time to buy Puts because the premiums (prices) are relatively low. Premiums vary with volatility; when implied volatility is low, as measured by common indicators such as the VIX, Puts are generally less expensive. The VIX is normally very low – below 15 – when Lottery Fever is underway, so Puts are cheap. Lottery Fever is therefore one of the best opportunities to protect stocks with Put options.
• Method #3 – Sell a Covered Call
  Selling Call options against stock that is already owned is known as selling a Covered Call, writing a Covered Call, or simply a Buy-Write. Unfortunately, the same process that makes Put options less expensive during Lottery Fever also makes Call options less expensive. That means a Covered Call trader won’t collect as much premium. It also means there is less protection if Lottery Fever comes to an abrupt end, because there is less premium collected to offset losses on stocks as stock prices fall.
• Method #4 – Collar the Stock
  A Collar combines a Put option as protection for a stock position with a Covered Call to generate income to pay all or part of the premium on the Put. Since both the Call and Put premium tend to increase and decrease in unison, a decrease in implied volatility (such as a decrease in the VIX) has minimal effect on a Collar. During Lottery Fever, a smaller premium is collected on the Call of a Collar, but the Put costs less to purchase. The Collar can thus be attractive in any market, including a low volatility (low VIX) market, because the net premium of the Put/Call combination does not change very much. Regardless of volatility, or a lack of volatility, the Put limits potential losses while the Call pays the premium for such protection. A stock owner can still experience gains if stock prices rise, as is common during Lottery Fever though gains are limited by the Call option of a Collar, but risk of loss is greatly reduced by the Put if Lottery Fever comes to an end.
• Method #5 – Sell a Bear Call Spread
  A Bear Call Spread consists of selling a Call option, to generate income, while buying a Call option at a higher strike price. Obviously, such a spread benefits the most when stock prices do not reach the strike price of the Call that is sold. However, don’t let the name fool you! Bear Call Spreads can be great for stock owners during Lottery Fever. That’s because a stock owner who sells a Bear Call Spread has unlimited profit on the stock. Net profit may be slightly reduced, since the short Call option creates an obligation to relinquish a portion of the profits, but the long Call option ensures net profit remains unlimited if Lottery Fever sends stocks skyrocketing. A Bear Call Spread also provides valuable income that can be used to offset losses on the stock if Lottery Fever ends. A Bear Call Spread is also, in many cases, independent of the stock, and thus gives the trader the ability to sell the stock if the price tumbles, without the obligation to buy back the Call option, as is commonly the case with both a Collar and a Covered Call. Since the Bear Call Spread is completely independent, a trader can also choose the number of contracts to suit his or her specific tolerance for risk. The more contracts, the greater the protection against an end to Lottery Fever, and the greater the reduction in potential profits from a continuation of Lottery Fever. Fewer contracts provide less protection when Lottery Fever ends but less of a reduction in profits if it continues.

These are just a few examples of the many possible steps a stock owner can take now, to reduce the risk of giving up all of those hard-earned unrealized profits if and when Lottery Fever ends.

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 1850 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 1850 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.

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 1950, Long Calls (and Married Puts) will remain profitable, suggesting the Bulls retain confidence and strength. Below 1950, 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, which balances sluggish responses of longer expirations with irrelevant noisy responses of shorter expirations.

The LSSI currently stands at +1.5%, which is unusually high, but still normal (below 4%), 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 2001. Values above S&P 2001 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 2077 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 1887 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 1887 would be a major bullish “buy the dip” signal, while a break below 1887 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