By Chris Ebert
Ever wonder why stock prices sometimes bounce higher after a decline, and other times do not bounce at all, but continue to fall?
It’s a phenomenon with which every trader and investor struggles. Sometimes a stock may behave like a bouncing ball, other times like a falling knife; and sometimes the market as a whole takes on these attributes, affecting a major stock index, for example the S&P 500, the Dow or the Nasdaq.
While no single explanation is likely to describe how a stock will bounce off a support level or fall through it, here is one worth consideration: It is not simply the act of hitting support that determines how or whether a stock price will bounce, it is how the act occurs; and that depends a lot on the nature of support itself.
Support can be:
Hard or soft
Fixed or in motion
Horizontal or tilted
The manner in which stock prices bounce off support, or in fact whether they bounce at all, can be entirely different if the support level is tilted at an angle, for example, than it would be if support was perfectly horizontal.
It’s actually quite similar to the way a ball might bounce differently upon hitting an incline than a flat surface, grassy soil versus a hard wooden floor, or a stationary bunt as compared to a baseball-bat amidst a home-run swing. Thus, if the nature of support is known, it should be easier for a trader to determine the outcome when a stock price hits that support level.
The following analysis of the S&P 500, which is presented right here each weekend, looks at the stock market from an option trader’s perspective. Of the many clues revealed by options are levels of support and resistance in the S&P 500. This week: a look at the nature of those levels, with insight on whether the S&P may act more like a ball or a knife in coming weeks.
* 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.
EXAMPLE: If Long Call premium paid is $2 when SPY is trading at $200, the loss is 1% if the option expires worthless.
You are here – Bull Market Stage 3 – the “resistance” stage.
On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending January 17, 2015, this is how the trades performed on the S&P 500 index ($SPY or $SPX):
Covered Call and Naked Put trading are each currently profitable (A+).
This week’s profit was +3.3%.
Click on chart to enlarge
Long Call and Married Put trading are each currently not profitable (B-).
This week’s loss was -1.4%.
Long Straddle and Strangle trading is currently not profitable (C-).
This week’s loss was -4.7%.
The combination A+ B- C- occurs whenever the stock market is at Bull Market Stage 3, the “resistance” stage, which gets its name from the tendency of stock prices to experience strong resistance, often like a brick wall, if recent highs are approached.
Hard or Soft?
A hard or soft level of resistance gets its hardness or softness from the significance of that particular level. Basically, there are two types of levels in the stock market: those that are consciously recognized by traders, and those that affect traders subtly on a subconscious level. Certain levels, of support, for example, are widely recognized by numerous market participants.
Take any level that has stood as support several times in the past, and it is likely that many traders will recognize that level as a possible level of significance for support in the future. Traders then use such a level to set their stops on stock positions, or to set the strike prices for their options positions. When the level gets hit, it is often no surprise that the market reacts, simply due to the abundance of stop orders being triggered and also the number of options positions reaching their strike price.
Many traders make a conscious effort to place stock stops or choose option strike prices that represent logical levels of support. The greater the consensus among market participants regarding the importance of a particular level, the harder that level is likely to seem, whereas levels that are less obvious and have less consensus tend to be softer.
If everyone agrees on $100 as being the ultimate level of major support for a stock, and the stock hits the $100 level, a bounce higher will tend to trigger buy orders from all around the world. The stock will bounce like a ball – a super-bouncy ball. The bounce is often exacerbated by the fact that short sellers of the stock, seeing the $100 level as a shorting opportunity, will quickly find themselves buying shares to cover their short positions when the stock price bounces higher.
However, if participants are divided between several levels, $99, $100, and $101, for example, the bounce can be more like that of an underinflated basketball than a Super Ball. While a tight consensus results in a V-shaped bounce, a loose consensus results in a more rounded cup-shaped bounce. A cup and handle is a typical result of s soft bounce, with the handle itself usually representing the highest level of support being debated, the cup carving out the lower levels.
As stated above, sometimes the levels of support and resistance are easily recognizable by market participants, and thus become part of the collective consciousness of traders. Others, however, are not so easily recognizable, and traders may react to levels they do not consciously observe, basing trades on a “feel” for the market. How many times have you looked at a chart and thought “this thing just feels like it wants to go higher” without any technical basis for your opinion?
Sometimes the market finds support or resistance in a place where it might not be obvious or expected. In those cases, the market can be said to have made an unconscious decision. The unconscious discovery of support or resistance is no less important than the conscious discovery. Support is support, no matter how it’s found; and the same goes for resistance.
Although it may seem like circular reasoning, bounces determine support and resistance, just as support and resistance determines where bounces will occur. Indeed, just as archaeologists have found that rocks date the fossils, the fossils date the rocks more accurately. So too do bounces reveal support and resistance more accurately than support and resistance determine bounces. Viewed in that light, bounces can reveal not only obvious conscious levels, but obscure unconscious ones as well.
If a bounce reveals a specific level of support or resistance, then the nature of the bounce (e.g. hard or soft) can accurately describe the consensus surrounding that level, even if the consensus was arrived at unconsciously.
Fixed or in Motion
Not all levels of support and resistance are stationary. Trend-lines and moving-averages are typically in motion; that is to say, the level changes with the passage of time.
When a stock price hits a support level head-on, with the two moving towards each other, the result can be a higher bounce than one might otherwise expect – a hard bounce. On the other hand, a stock price that falls onto a support level when the support level itself is also declining may experience a more subdued bounce – a soft bounce.
Using the famous archaeological analogy, a hard V-shaped bounce can therefore sometimes indicate that a support level is rising into the stock, in essence propelling the stock with its momentum. The bounce describes the support level and the support level describes the bounce. Conversely, a softer cup-and-handle type bounce can sometimes signal that the support level itself is in decline.
Horizontal or Tilted
Another way of looking at a level of support or resistance that is not fixed, but where the level is changing with the passage of time, is that the surface formed by the support level is tilted. A stock will bounce differently when encountering an uphill support level than it will if the support level is flat or is pointed downhill. A basketball will bounce differently from the jagged surface of an outdoor playground than from the smooth floor of a gymnasium, especially if the ball lands on the sloping side of a pothole.
Thus, when a stock bounces violently in a V-shape, it can be inferred that the surface of support it hit is pretty much horizontal. A stock that bounces sideways from support may have done so due to the fact that the support is pointed downhill. A downhill slope can often propel the stock sideways with more momentum than it can propel it upwards. By corollary a stock that bounces sideways can imply that the support level underneath is tilted downwards.
A downward-facing slope for support can result in the stock falling further than one might expect with a horizontal support. As long as support is tilted down, a stock may tend to form lower lows.
To an untrained observer, a stock making lower lows may appear to have no support at all. But when one envisions tilted support, lower lows can be explained logically, perhaps giving a trader an opportunity to buy the stock that others may see as a poor choice. Tilted support is the basis for some very bullish chart patterns, including bull flags and pennants.
Bouncing Ball or Falling Knife
Sometimes stocks bounce off of support or resistance and other times they go through like a knife through butter. Knives tend to cut best when the impact is direct, as opposed to a glancing blow. A glancing blow is more likely to result in a bounce, not necessarily a bounce right back in the opposite direction, sometimes a sideways bounce, but still… a bounce nonetheless.
The most dangerous environments for falling knives, therefore, are presumably those in which the stock price is moving at a direct 90 degree angle towards support. A stock is most likely to cut right through support if it approaches support at a right angle.
Similar to light passing through glass, the angle of incidence determines the angle of reflection or refraction; some of the light bounces off the glass, some goes right through it. When the light shines on the glass directly, more light passes through than when it shines on it at a steep angle. Try avoiding the sun-glare off the car in front of you in early morning or late afternoon traffic, and you’ll understand the importance of the angle of incidence.
Stocks are more apt to pass through support when they make a direct hit. Not all stocks that make a direct hit become falling knives, though. That explains why the ones that do bounce, bounce violently, like a Super Ball. The sense of relief is always greatest when the potential for a falling knife is the greatest, and that potential disappears. The sense of relief after a bounce – a bounce that could have been a falling knife, but wasn’t – is what produces the distinct V-shape on a chart.
Options Show Glancing Blows
The chart shows the different zones for the S&P 500 based on the profitability of several options strategies. Since each zone has a different character, the dividing line between each zone acts as a potential level for support or resistance.
When the S&P approaches the dividing lines between the zones, it is more likely to cut through to the next zone if it makes a direct hit, at a 90 degree angle. Otherwise, glancing blows can generally be expected to produce sideways bounces.
Over the next few weeks, through about mid-February, the support/resistance levels formed by these dividing lines are tilted downward. If the S&P strikes these dividing lines over the next several weeks, the blows will likely be glancing ones. That makes falling knives less likely to occur through mid-February. As can be seen on the chart, it doesn’t mean the S&P can’t sink lower in coming weeks, as bounces off support could easily produce lower and lower lows.
It would seem more probable that if the S&P was to become a falling knife, it would be more likely in February and March (when the support levels are again tilted upward) than during January (when the support levels are still tilted down). It would be easier for the S&P to make a direct hit in February or March than in January, and a direct hit, should it occur, will reveal whether the S&P 500 is a falling knife or a Super Ball.
Until then, until a direct hit into support, it could very well be a series of glancing blows, and soft bounces, sideways bounces, or perhaps bounces to lower lows. On the other hand, a rally in the S&P would take nearly direct aim at resistance. The S&P could conceivably cut through the yellow line, perhaps even the blue line, like a knife, which would put it on track to test the all-time highs very quickly. Such a direct blow at resistance is not guaranteed to cut like a knife, so a bounce back from such a direct hit could send the S&P into a tailspin. Traders should be aware of the implications for a rejection of Stage 2 by the market, if it takes aim at the blue line and fails to cut through.
The following weekly 10-minute 3-step process provides further analysis.
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.
Historically, any time Covered Call trading has become unprofitable, a full-fledged Bear market has ensued within a few weeks to, at most, a few months. That makes the recent October 2014 dip into unprofitability, the first such instance in 3 years for Covered Calls, a major signal for the potential of an upcoming Bear market within the following four months… through approximately the end of February 2015. As bullish as the current market may appear, traders should be open to the possibility that a Bear market is certainly not impossible.
The unprofitability of Covered Call trading does not guarantee that a Bear market will occur soon, nor does it imply that stock prices cannot rally much higher in coming weeks. Rather, it indicates that similar conditions as currently exist have always resulted in Bear markets in the past. Traders should be prepared for the possibility that the most recent rally was a trap. Even if it turns out not to be a trap, it is better to be safe than sorry.
If the S&P falls below 1904 over the upcoming week, Covered Call trading (and Naked Put trading) will become un-profitable, indicating that the Bears have regained control of the longer-term trend. Above S&P 1904 this week, Covered Calls and Naked Puts would be profitable, which is normally a sign that the Bulls are in control. However, such control is usually only temporary as long as the Bulls lack strength and confidence.
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 losses returned several weeks ago, a major sign of a lack of bullish confidence and strength. While Long Call losses by themselves are not a sign that the Bears have taken control, the loss of confidence that occurs when Long Call trading is unprofitable can quickly reveal underlying bearish tendencies unless a sustained rally occurs within a few weeks.
Once Long Call losses are occurring, a propensity for profit-taking often sweeps over market participants – a propensity that generally lasts for at least several weeks. If a Bull market can endure this propensity without suffering a major correction, it can be strong indicator of future growth in stock prices. A market with bearish tendencies can rarely endure the added burden of a widespread propensity for profit-taking, at least not without suffering a major pullback or correction.
If the S&P manages to close the upcoming week above 2030, Long Calls (and Married Puts) will retain profitability, suggesting the Bulls have retained confidence and strength. Levels above 2030 would suggest a continuation of recent sentiment, notably confidence by the Bulls. Below 2030, weakness and a lack of confidence should be abundantly apparent.
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 create brick-wall resistance, since each high is perceived as a rip to be sold. In a true Bear market, the Bulls will never be confident and strong; thus, Long Calls and Married Puts will never profit during a Bear market. Profits are therefore compelling evidence that the Bulls are firmly in control.
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 Either 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 -4.7%, which is barely normal and becoming a level of concern, as it is indicative of a market that has become overly range-bound and therefore nearing a level at which it is “due for a breakout” from the range of the past few months..
Range-bound markets tend to demand a breakout in prices from the range of the past several months. A breakout can always occur for other reasons, for example surprising economic news. But a breakout can also occur for seemingly no reason at all, other than the fact that traders have become anxious due to several months of range-bound stock prices. Currently, a breakout is becoming more likely to occur on its own accord, perhaps even without any sufficient news catalyst, because the LSSI is becoming abnormally low. An LSSI below -6.0% is considered extreme.
Over-extended markets tend to demand a correction, at least temporarily. A correction can occur for other reasons, such as a news catalyst, but can occur without any catalyst at all when the LSSI is abnormally high. Currently, no correction is likely to occur of its own accord, without a significant news catalyst, because the LSSI is not abnormally high. An LSSI above +4.0% is considered extreme.
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 become profitable during the upcoming week only if the S&P closes above 2093. Values above S&P 2093 could only occur during an irrationally exuberant Bull market. Values above 2112 would therefore suggest the presence of an overbought market, but sustainably overbought – as occurs during the Lottery Fever Stage.
Excessive Long Straddle trading profits (more than 4%) will not occur unless the S&P either exceeds 2172 this week. Values above 2172 can only occur in a roaring Bull market, but would suggest that stock prices have risen too far too fast for the rate to be sustainable, thus needing to correct lower, at least temporarily, in order to return to sustainability for the uptrend. 2172 therefore represents the extreme upper limit of the Lottery Fever Stage.
Excessive Long Straddle losses (more than 6%) will not occur unless the S&P moves to very near 1975 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 level of the S&P near 1975 would likely bring a violent snap-back rally or else a violent resumption of the most recent downtrend. The 1975 level therefore divides an ordinary ‘pullback’ (above it) from a significant Bull-market ‘correction’ (below it).
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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