How To Prepare For Bull Market Stage 3

By Chris Ebert

Stocks and Options at a Glance

It looked as though Bull Market Stage 3 was about to begin during this past week, but the S&P 500 showed just enough strength to keep that from happening. For now, Bull Market Stage 2 continues, which is a stage in which the market can be considered to be “digesting” its recent gains.

A change to Stage 3 would have been a significant development, because once that stage is underway, recent highs in the stock market tend to become much more difficult to surpass. The fact that Stage 3 was not confirmed this past week supports the argument that it is possible the market has not yet topped out for the near term. It does not mean the S&P will necessarily reach new record highs in the coming weeks, and the market may indeed not reach those highs anytime soon, but at the current Stage 2, those record highs still present some danger of being broken.

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 SPY

You Are Here – Bull Market Stage 2

Click Here for a complete chart of all Options Market Stages

Bull Market Stage 2, while not as bullish as the “lottery fever” mania of Stage 1, is nonetheless still a bull market, at least until it is proven otherwise. When prices become choppy or move sideways in Stage 2, it is often just a sign that the bulls are taking a break, gathering strength, and preparing for the stock market's next leg up.

Stage 2 is known here as the “digestion” stage, because under the current market conditions, the reasons for thinking that this is anything other than normal digestion are usually open to debate. Sure, this could be the beginning of the end. But, it could also be the beginning of a new uptrend. It is what happens next that will ultimately determine which will determine which of those opinions is correct.

Preparing for What Will Happen Next

If Long Call trading remains profitable:

Stage 2 is a market in which the uptrend is still strong enough to allow at-the-money Long Call option trades to return a profit, but not strong enough to generate a profit by trading at-the-money Long Straddles. If Long Call trading continues to return profits in the coming weeks, then this will likely prove to be the beginning of a new uptrend. But, if Long Call trading stops producing profits, the case for the beginning of the end will become stronger. Even so, the beginning of the end often turns out to be nothing more than a healthy bull-market correction.

If Long Call trading becomes unprofitable:

The reasoning behind a gloomy outlook, if Long Calls stop profiting, is that such a scenario would represent a significant loss of upward momentum for stock prices. For most of 2013, momentum has been strong, and Long Calls have been profitable.

When traders buy stocks during periods of such strong momentum, a temporary decline in stock prices is perceived as a temporary setback. When the setback is over and stock prices return to the purchase price, traders tend to perceive it as confirmation that the original choice – to purchase – was correct. Since the choice to buy was correct, but a little premature, then holding the stock when it returns to the purchase price tends to seem even “more correct”, because it is no longer premature.

The same thought process is not as common once momentum has slowed to the point where Long Call trading can no longer turn a profit. Traders who buy stock and experience a temporary setback are more likely to see a return to the purchase price as a gift – a chance to undo past mistakes. Since the original choice to buy stock may later be seen as incorrect once the pace of an uptrend slows, selling stock when it returns to the purchase price becomes more common.

It is difficult for a stock price to rise above a specific level when there are more traders looking to sell that stock if it reaches that level than there are traders willing to buy it at that level. So, the stock price meets resistance when it rises to that level. Long Call trading losses tend to correlate with a shift in sentiment such that sellers will outnumber buyers if prices re-test recent highs. This shift in sentiment defines Stage 3 – the “resistance” stage.

A loss of profitability on Long Call trading will occur this coming week if the S&P ends the week below 1679. Since the S&P currently stands at 1663, that means it must climb at least a little bit this week, otherwise Long Call profits will disappear and Stage 3 – the “resistance” stage will begin. Traders who are ready for the possibility of Stage 3 will be prepared for a significant shift in sentiment if it does occur, especially since it would be the first time the market reached that stage in 2013.

To summarize the Options Market Stages for the upcoming week ending August 31, 2013:

S&P over 1724 indicates a return to Stage 1 lottery fever.
S&P between 1679 and 1724 indicates the market is continuing Stage 2 digesting gains.
S&P between 1626 and 1679 indicates recent highs may become strong resistance in the future.
S&P between 1588 and 1626 indicates a correction is underway.
S&P under 1588 indicates the presence of a bear market.

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.

This week, Covered Call trading and Naked Put trading were both profitable, as they have been for an extended period. In fact, Covered Call trading became profitable in late 2011 and has remained profitable every week since then except for two very minor losses. That means the Bulls have been in control since late 2011 and remain in control today. As long as the S&P remains above 1588 over the upcoming week, the Bulls will 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.

This week, Long Call trading and Married Put trading were both profitable, as they have been since February 1, 2013. That is a historically long streak of profitability, but profits have drifted lower in recent weeks. Those smaller profits may be temporary, but if they disappear altogether it would mark an important shift in bullish confidence. As long as the S&P closes the upcoming week above 1679, the Bulls will retain 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 -2.6%, which is significant, since it represents a decrease in the rate of the current uptrend in stock prices; and that is something that has been rare so far in 2013. For much of the year to date, Long Straddle trading has been unusually profitable. Losses on Long Straddle trades are historically common, and normal, so long as those losses do not fall below -6%.

A level of the S&P of 1626 this coming week would push the LSSI near -6% signaling that the market was “Due for a Breakout”. When such a level is reached in a longer-term bull market, such as the current one, it can mark an important turning point. Either stock prices break out higher, ending the pullback, or they break out lower and confirm that a more significant pullback – a correction – is 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.

Updates to the above analysis may be found at @optionscientist

Questions, comments and constructive criticism are always welcome. Enter them in the comment box below, or send them to OptionScientist@zentrader.ca.

The preceding is a post by Christopher Ebert, who uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. He studies options daily, trades options almost exclusively, and enjoys sharing his experiences. He recently co-published the book “Show Me Your Options!”