This month, May 2014, may very well represent the last chance for a major Bull-market correction for at least the next several months.

In the following analysis of stock options, it will be shown that from now through at least September, any dip in the S&P below approximately 1800 would be a strong indication of the presence of a Bear market, with one exception. For the month of May, the S&P could test 1700 without signaling a Bear market.

That means that if stocks do not experience a major sell-off during this current month of May, they likely won’t be able to experience a major sell-off in coming months without triggering bearish headlines. In other words, beginning this June, the market will lack the ability to experience a healthy Bull-market correction for several weeks, or perhaps months; and only then would it be possible if the S&P was to rally high enough that the 1800 level represented a major correction off of the highs.

To begin the analysis, we look at three basic option trades on the S&P 500, and use the performance of those trades to determine the current state of the stock market.

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 (NYSEARCA:SPY)

You are here – Bull Market Stage 3.

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

• Covered Call trading is currently profitable (A+). This week’s profit was +2.7%.
• Long Call trading is currently not profitable (B-). This week’s loss was -0.6%.
• Long Straddle trading is not currently profitable (C-). This week’s loss was -3.2%.

Using the chart above, we can see that the combination, A+ B- C-, occurs whenever the stock market environment is currently at Bull Market Stage 3. For a description of Stage 3, as well as a comparison to all of the other stages, follow the link below:

Click here for complete descriptions of all individual Options Market Stages.

What’s next?

We can see that the current environment for stocks is bullish, but at the same time comprised of a large amount of resistance from above. In fact, the S&P has acted as if it was attempting to surpass the 1880 level several times in recent weeks, only to fail to maintain that level. In some ways, the 1880 level has acted like a brick wall.

Brick-wall resistance has been historically common during and immediately following each occurrence of Bull Market Stage 3. Sometimes brick-wall resistance can help induce a healthy correction. After all, in general, stock prices have gone basically nowhere so far in 2014 – hardly the type of market that attracts buyers in droves. The lack a trend can lead to a lack of buyers, which in turn can lead to sellers being forced to accept lower prices for their shares.

Lower stock prices are a good thing during a healthy Bull-market correction. They attract new buyers from the sidelines and reinvigorate the market, provided they do not go too low. So, how low is too low? Well… historically “too low” is anything below a point at which Covered Call* option traders can make a profit. As long as Covered Calls are profitable trades, any correction, no matter how deep, is nothing more than a correction.

On the following chart, the red line depicts the division between Covered Call profits and losses. Thus, no matter how far the S&P falls, as long as it remains above the red line, it is still a Bull market – a Bull market in correction, perhaps = but a Bull market nevertheless.

If the S&P falls below the red line, Covered Call traders will fail to profit. Historically, Covered Call trading losses have been a harbinger of Bear markets, so such losses are often an important signal that stocks are selling off more than would be expected in a healthy correction.

For most of the remainder of this month, the red line is near the 1700 level on the S&P. That means the S&P could conceivably sell off to somewhere near 1700 and Covered Call traders would not see significant losses, indicating nothing more than a healthy correction was underway.

If, however, the stock market does not experience a correction before this month of May is out, the line dividing Covered Call profits and losses – in other words, the line separating a Bull market from a Bear market – will rise to near 1800 in June. Thus, anything below approximately 1800 would be indicative of something unhealthy, something more than a correction, something bearish, should it occur after May is over.

Since the S&P is currently in the mid-to-upper 1800s, it just isn’t possible for it to experience a major sell-off without bringing it well below the 1800 level. From the current level near 1880 to the 1800 level is about 80 points, so getting there would require a sell-off, but not one worthy of major headlines screaming “CORRECTION!”.

If we make it to June without a major correction, there will then be no way we can have a major correction without the S&P falling below 1800; and such a scenario would indicate the presence of a Bear market. Therefore, it is not possible for the S&P to experience a major sell-off (10% or more) as part of a healthy Bull-Market correction  unless:

1. It occurs in May, while the S&P could conceivable fall 180 points, or 10%, from its current level near 1880 and still be at or above the red line on the chart, currently near 1700. Or:
2. It occurs after May, but only after the S&P has first rallied to 2000 or so, giving it the ability to fall 10% without going below the red line, which would be near 1800 at that time.

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 1788 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. 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.

Long Call trading became unprofitable this past March, and those losses intensified during April. 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.

Failure of the S&P to close next week above 1889 would be a sign of continued weakness; and weakness always has the potential of putting downward pressure on stock prices. If the S&P fails to close the upcoming week above 1889, Long Calls (and Married Puts) will fail to profit, suggesting the Bulls have lost 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.

The LSSI currently stands at -3.2%, which is low but not quite at the level of -6% considered excessive. Low levels, especially those below -6%, have historically been followed by major breakouts in which the S&P moves out of the trading range of the past several months. Breakouts can either occur as the S&P soars to new highs or else makes lower lows than it has experienced for quite some time.

Negative values for the LSSI represent losses for Long Straddle option trades. Losses, when excessive, represent one of three unusual conditions for Long Straddle trading, each with a distinct prognosis for the stock market.

Unusual Condition #1 – Profits on Long Straddle trades are unusual.
Profits on Long Straddle trades will not occur this coming week unless the S&P exceeds 1939. The S&P exceeding that level this upcoming week would indicate that Bull market of 2013 was once again underway and the recent correction/consolidation was simply a pause in the uptrend. Such profits, while unusual, are usually not a major concern unless they become excessive.

Unusual Condition #2 – Excessive profits on Long Straddle trades are very unusual.
Excessive profits on Long Straddle trades, such as those exceeding 4%, will not occur this coming week unless the S&P rises above 2013. Despite the presence of euphoria if the S&P was to reach that level, anything higher than 2013 this coming week would be absurd and would likely to result in some selling pressure. Historically, such absurd bullishness has been associated with subsequent pullbacks and, occasionally, major Bull-market corrections. In any case, 2013 is probably out of reach this coming week.

Unusual Condition #3 – Excessive losses on Long Straddle trades are just as unusual as excessive profits.
Excessive losses on Long Straddle trades, such as those exceeding 6% will not occur this coming week unless the S&P nears 1829. Excessive losses often occur when an extended stalemate between the Bull and the Bears has reached its limit and one side or the other is about to achieve a victory. Thus, at or near S&P 1829 this coming week a subsequent breakout is likely.  Since the S&P is currently not terribly far from that 1829 level, the chances of a major breakout are elevated now. As mentioned in Step 1, if a breakout brings about a lower trading range, especially below 1788, it could be a very, very bearish signal, while a bounce higher from the 1788 area would be a strong indicator that the market had put in a bottom, at least temporarily,  at a level of strong support.

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