Last week, readers here were alerted to the possibility that if the S&P 500 did not experience a pullback, it was likely to rally. Thus, the expectation was for either 2000 or bust for the S&P over the next few weeks.
The reasoning has not changed this week – the S&P continues to act very bullishly. In fact, stock prices have increased so quickly that they are nearly at a point where they could soon affect the performance of some simple option trades, and if so, those option trades would then indicate a stock market that is as bullish as it gets.
The option trades worth watching over the next week or so are Straddles and Strangles.
- When either of those strategies is applied to the S&P as a whole, any resulting profit is an indication of widespread extreme bullishness.
- Extreme bullishness tends to induce euphoria among traders.
- Such euphoria tends to have similarities to the “lottery fever” that often surrounds large lottery jackpots.
- A market in which Straddles and Strangles on the S&P are profitable is known here as Bull Market Stage 1 – the “lottery fever” stage.
While the S&P has not quite climbed high enough to reach Stage 1, another 25 points or so is all it would take to make the transition. The stock market continued to experience the mild bullishness of Stage 2 – the “digesting gains” stage this past week, but anything above 1902 over the upcoming week would likely unleash extreme bullishness of lottery fever of Bull Market Stage 1.
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 2
Recognizing whether the stock market is currently at Stage 2 requires a quick analysis of the three categories (A, B, and C) of option strategies shown in the chart above, using a plus (+) for profitable strategies and a minus (-) for unprofitable ones.
- Covered Call trading is currently profitable (A+). This week’s profit was 2.7%.
- Long Call trading is currently profitable (B+). This week’s profit was 2.1%.
- Long Straddle trading is not currently profitable (C-). This week’s loss was 0.5%.
The combination, A+ B+ C-, occurs whenever the stock market environment is currently at Stage 2. In order for the market to switch to Stage 1, category C trades – Straddles and Strangles – must become profitable once again. Since profitability is shown with a “+” sign, the switch to Stage 1 would result in a C+ for Long Straddle Trading. The combination of A+B+C+ occurs whenever the stock market is under the influence of Stage 1 lottery fever, and can be seen on the chart above. The implications of lottery fever may be seen on the chart below.
What Happens Next?
When the euphoria of Bull Market Stage 1 takes over the market, the S&P tends to climb as high as it can go until it hits resistance. There is always the chance that something unforeseen could derail the S&P (war, disaster, etc.), so there is never a guarantee that the S&P will soar during lottery fever. But, the general trend under the influence of euphoria is usually towards the highest stock prices that the market can tolerate.
Many times, there are tangible levels of resistance for the S&P, and it is therefore expected that stock prices will stop rising, at least temporarily, when the S&P has reached one of those levels. Such levels often exist at old high prices, or places at which the S&P has experienced strong support or strong resistance in the past. However, with the S&P now at all-time highs, no such levels exist.
