Ever notice how the stock market seems to have a mind of its own, as if it is determined to separate you from your stock positions? If so, you are not imagining things. The stock market is indeed hunting you down; but don’t take it personally. It is simply the nature of the stock market to break the bonds between stocks and stockholders; and it’s called entropy.

Entropy is, quite simply, a tendency toward disorder. It isn’t confined to the stock market. Entropy favors an organized, predictable stock market as much as it favors a sand castle on the beach or a hot cup of coffee. Without outside influence, in time, each of these will return to their natural, disorganized state – the coffee’s organized collection of heat scattered haphazardly throughout the air just like the castle’s organized grains of sand on the beach or stock prices from any level that conveys certainty or order.

Some stock price levels convey more certainty for traders than others. Since the natural tendency is always towards a level of increased uncertainty and increased disorder, knowing which levels are likely orderly and which are prone to be disorderly man help a trader prepare for the next move.

Predicting order is nothing new. In fact, it is the basis for many common trading methods. From candlestick analysis to Darvas boxes, trend lines to Fibonacci retracements, the goal is the same – to search the market for fleeting moments of certainty and order, and pounce on them before entropy runs its course.

There are numerous ways a trader can analyze potential levels of order and disorder, the performance of some simple stock options being one of the simpler methods. An analysis of S&P 500 options may provide some clues as to when broad-based uncertainty and disorder is likely in the stock market as a whole, and when it is not. It begins with determining which types of common option trades on the S&P 500 are currently profitable.

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

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 August 16, 2014, this is how the trades performed:

• Covered Call and Naked Put trading are each currently profitable (A+).
  This week’s profit was +3.1%.
• Long Call and Married Put trading are each currently profitable (B+).
  This week’s profit was +1.7%.
• Long Straddle and Strangle trading is currently not profitable (C-).
  This week’s loss was -1.4%.

Using the chart above, it can be seen that the combination, A+ B+ C-, occurs whenever the stock market environment is

Click on chart to enlarge

at Bull Market Stage 2, known here as the digesting gains stage. This stage gets its name from the tendency for stocks to experience periods of gains interspersed with relatively minor pullbacks, each temporary pullback being the market’s way of digesting the prior gain.

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

Pinpointing Likely Zones of Certainty and Uncertainty

The more uncertainty that exists at a particular stock price level the more likely the stock price is to be at that level. Therefore, any level that conveys certainty will likely be short-lived, while any level that raises doubts will tend to persist. This is due to the simple fact that doubt promotes indecision, while certainty gives traders the confidence to act.

The more orderly the stock price, the more likely it is that the stock will attract trader’s attention, thus the more likely it is that traders will push the stock price away from the very same level that made it attractive in the first place.

Some levels that may convey a high sense of uncertainty, since it is often difficult to know how traders will react at that level:

• An all-time high price
  (it is difficult to know if traders will jump in at the high or take their profits)
• A recent high price that preceded a pullback lower
  (folks who bought prior to the pullback may be itching to get out)
• A recent low price that preceded a bounce higher
  (many stop losses may be tripped if the price hits that low again)
• A recent price gap
  (traders may be weary of the gap being filled)
• A level at which the price stalled for an extended period of time in the recent past
  (fears of price stagnation may push traders to stocks that are making moves)
• Levels of commonly-used moving averages
  (self-fulfilling prophesy may exist when many stops are placed at common levels such as 50-day, 100-day, 200-day)
• Levels of commonly-used Fibonacci retracements or extensions
  (self-fulfilling prophesy may come into play at 0.618, 1.618)
• Psychologically-important round numbers
  (some traders may react to big round numbers such as 2000 level for the S&P 500)

Some levels that may convey order, certainty, and confidence:

• Confirmed exceedance of resistance at an all-time high or recent high
• Bounce higher off support at a recent low, a recent gap, a commonly-used moving-average or Fibonacci retracement
• Breakout above a big round number
• Basically, any movement away from a level of uncertainty

Using Option Performance to Confirm Certainty and Uncertainty

Even with the above examples of orderly and disorderly levels as a guide, any trader who has been around for a while knows that stock prices sometimes honor these levels and sometimes ignore them like they don’t exist. A stock price can sometimes blow through a 100-day simple moving average like it was nothing, despite the number of buy orders that would normally be expected to provide support at such a commonly-used technical level.

For help avoiding such surprises, it may be helpful to consider that the options market defines some zones of order and disorder as well. Thus a trader might be more cautious trusting, say, a bounce off the 100-day sma if the options market was indicating a possible area of uncertainty and disorder at the level of the 100-day sma, since stock prices tend to seek uncertainty and disorder, making a return to that level a distinct possibility.

Alternatively, if the options signaled certainty and order at the 100-day sma, a bounce towards a more uncertain level might give a trader more confidence.

Since the options market progresses through some very distinct stages (known here as the Options Market Stages), each stage having a degree of certainty and order, uncertainty and disorder are most likely to exist between stages, or at the very edges, not near the center of each stage.

A recent article discussing the link between Doji candlesticks and Options Market Stages may be found here: Stock Options Explain Doji Candles

The dividing lines between Options Market Stages are among the most disorderly levels for stock prices. Entropy therefore favors the S&P 500 hugging the dividing lines. When the S&P 500 is centered in the middle of an Options Market Stage, it doesn’t usually stay there long. That’s because traders quickly become accustomed to the trading environment when the environment is easily defined.

For example, when traders realize a Bull market has simply paused to digest some gains, the certainty of that reasoning may cause them to consider keeping stocks they were prepared to sell, perhaps adding to long stock positions, or maybe widening stops a bit. However, if the S&P is teetering on the brink of two Options Market Stages, traders may find the environment more difficult to assess, thus less likely to make any changes to a trading plan. The center of each Stage promotes change, the edges promote the status quo. Thus, the S&P is drawn to the edges like a

In the above chart it can be seen that the S&P 500 is currently squarely in the middle of Stage 2. Thus, it would be expected that entropy would soon push the S&P either up, to the dividing line between Stages 1 and 2, or down to the line between Stages 2 and 3. Those levels, the levels of highest entropy, are currently at 1988 and 1935, respectively. Thus, a move to 1988 or 1935, at any time in the next week or so, would be quite natural.

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 1828 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 1828 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 1935, Long Calls (and Married Puts) will remain profitable, suggesting the Bulls retain confidence and strength. Below 1935, 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 -1.4%, 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 1979. Values above S&P 1988 would suggest a return to 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 2060 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 1875 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 1875 would be a major bullish “buy the dip” signal, while a break below 1875 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

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