Market Overview

Stock Market Bull Run Isn't Done Until…

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By Chris Ebert

This is either the beginning of the end for the recent 3-year uninterrupted run for the Bull Market and stock prices are headed much much lower;  or it's the end of a healthy Bull-market correction and stock prices are in a position to surpass their recent all-time highs within a few short weeks. The two scenarios are polar opposites. Now may be a good time for a trader to consider using option performance as an indicator of which path the stock market is on at the moment. Everyone can use options, even folks that don't trade options, if for nothing other than a second opinion of where stocks are headed.

The S&P has currently finished Stage 4. That means it will soon enter Stage 5, perhaps as soon as this coming week.  Another significant dip in prices without a recovery by week's end suggests Bear Market Stage 5 has begun. The slightest rally in stock prices without losing ground by week's end suggests the recent sell-off is done and the Bull market Stage 5 is on it's way.

Options Market Stages 2014-10-11

* 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. (e.g. Profit of $6 per share on an expiring Long Call would represent a 3% profit if $SPY was trading at $200, regardless of whether the call premium itself actually increased 50%, 100% or more)

You are here – Bull Market Stage 4 – the “Correction” Stage.

On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending October 11, 2014, this is how the trades performed on the S&P 500 index ($SPY or $SPX):

Options Market Stages

Click on chart to enlarge

  • Covered Call and Naked Put trading are each currently not profitable (A-).
    This week's loss was -0.5%.
  • Long Call and Married Put trading are each currently not profitable (B-).
    This week's loss was -2.4%.
  • Long Straddle and Strangle trading is currently not profitable (C-).
    This week's loss was -1.9%.

The combination A- B- C- would suggest the S&P 500 has entered a Bear market (Bear Market Stage 5) for the first time since November 2011. However, the Options Market Stages are intended as guidelines. They are not designed to be so rigid that a very small loss, for example the 0.5% loss for Covered Call trading, defines a Bear market.

This past week saw the S&P fall below the 1916 level – the level at which at-the-money 4-month-out Covered Call option trading became unprofitable. Normally, the unprofitability of those particular Covered Calls signals that a Bear market is underway; and it very well may be underway. But, 10 points (0.5% of the current S&P 500 level) is too small a margin to make such a bold statement with confidence, especially when considering the margin of error on calculating the profitability of such option trades. 20 points, maybe, but 10 is far too small.

Without confirmation – either by Covered Calls experiencing a second consecutive week of losses, or by Covered Call losses growing larger than 0.5% (larger than 10 points on the S&P) – it could prove to be a serious mistake to assume the Bull market has ended and a Bear market has begun. If the S&P remains below 1912 through the end of the upcoming week, especially if it closes below 1912 this coming Friday, it would go a long way towards providing confirmation that a new Bear market was underway.

A close below S&P 1912 for the upcoming week ending October 18 would cause Covered Call trading to suffer its second consecutive week of losses. That's very rare outside of a Bear market. Without confirmation of a Bear market, it should be assumed that the Bull market is still intact, and that the current sell-off was nothing more than a healthy correction.

Using the chart above, it can be seen that the combination, A+ B- C-, occurs when the stock market environment is at either Bull Market Stage 4 or Bear Market Stage 4, each known here simply as the correction stage. This stage gets its name from the tendency for stocks to experience a need to test for support, but nothing more serious than that. All a healthy correction seeks is for support to be found; when support has been found the correction is over. Until Stage 5 is confirmed, either as Bull Market Stage 5 or as Bear Market Stage 5, it must be assumed that the correction is ongoing.

To say “the Bull is gone and the Bear has begun”, or to say “the Bull is back and the correction is over” is premature until Stage 5 is confirmed one way or the other. Category A trades need to be more than just a few points on the + side or a few points on the – side to make such a confirmation. This wiggle room is due to differences that would have arisen in the calculations had a different expiration date (other than 4-months) been used. While 4-month-out options have historically been an accurate guide, there is nothing magical about 4-month expirations. Typically, differences of 1% or more can be expected using slightly different expiration dates, so +/- 20 points of the current S&P level would not be unreasonable for a minimum margin of error when analyzing Category A trades.

How to Recognize Bull Market Stage 5

If Covered Call trading quickly becomes profitable again in the upcoming week or so, there is a good chance the recent sell-off for the stock market was nothing more than a healthy, long overdue Bull-market correction. Since 4-month-out Covered Calls, opened at-the-money (ATM) will experience a gain when they expire this coming week, only if the S&P is at 1912 or higher, then it stands to reason that 1912 is an important level.

Again, it is important to note that precision is not as important here as the context. 10 points either side of 1912 is certainly too close to provide a reliable indication. In context, if the S&P 500 finds support near its current level, somewhere in the general neighborhood of 1912, or if it moves higher, there is a good chance the Bull market could come back quickly and come back strong, perhaps stronger than ever.

It is not out of the question that new all-time highs could be set within weeks if the Bull market comes back to life. That's why Bull market Stage 5 is known here as the “All Clear” stage. Confirmation that the S&P has found support without causing major losses for at-the-money 4-month-out Covered Call trades, is one of the most bullish signs the market can send.

Some of the most significant rallies the stock market has ever experienced have come during Bull Market Stage 5, including:

  • July 6, 2012 S&P 500 entered Bull market Stage 5
    and gained over 100 points by early September.
  • June 1, 2012 S&P 500 entered Bull Market Stage 5
    and gained nearly 100 points by month's end.
  • June 10, 2011 S&P 500 entered Bull Market Stage 5
    and gained nearly 70 points by the end of that month.
  • August 20, 2010 S&P 500 entered Bull Market Stage 5
    and gained over 100 points in the following 6 weeks.
  • September 7, 2007 S&P 500 entered Bull Market Stage 5
    and gained nearly 100 points by month's end.
  • August 11, 2006 S&P 500 entered Bull Market Stage 5
    and gained nearly 200 points in six months, 100 of it in just 2 months.

How to Recognize Bear Market Stage 5

If Covered Call trading either remains unprofitable over the next week or so (if the S&P remains below approximately 1912) or if Covered Call losses become significant (if the S&P falls into the 1800s) then it will become much more likely that Bear Market Stage 5 is underway. Basically, the longer the S&P remains below the red line in the chart below, the more likely it is that a Bear market is fully entrenched.

Options Market Stages 2014-10-11

Bear Market Stage 5 is known here as the “Oh No!” stage. That's because it tends to occur surprisingly fast, taking traders by surprise. In fact, one of the tell-tale signs that Bear Market Stage 5 is underway is that Long Straddle option trading often becomes profitable. Profitability of Long Straddles usually requires a surprisingly large move in stock prices. When a sell-off causes at-the-money 4-month-out Long Straddles to return a profit, it's safe to say that a Bear market is underway.

One of the common developments when a fresh Bear market begins is for Long Straddles to become profitable. The effect does not tend to last very long; stock prices tend to bounce higher, temporarily, at or near the time that Long Straddle profits appear. This effect is very commonly referred to as the dead cat bounce, a perverse yet apt description of how stock prices can bounce even when the stocks themselves are dead, presumably in the same manner as a dead cat might bounce when dropped from a sufficient height.

It is often too late to react to a Bear market if a trader looks for Long Straddles to profit before exiting long stocks. That's why one of the most consistent definitions of a Bear market is that it is underway the moment Covered Call trading turns verifiably unprofitable. As indicated in the examples above, it is very important to make sure it is truly a Bear market before reacting, since a Bull market can come back stronger than ever unless it is truly dead.

Long Straddle profits would occur this coming week if the S&P falls below 1864. Thus, for those who may still not be convinced that a Bear market is underway at that level, Long Straddle profits should serve as a wake-up call – a late wake-up call, but a wake-up call nonetheless.

Conclusion

If the S&P closes the upcoming week, ending October 18, 2014,  above 1912, Covered Calls will be profitable and Bull Market Stage 5 will likely be underway, thus stocks may be headed towards recent all-time highs, perhaps surpassing them in coming weeks. If the S&P struggles this coming week, and closes below 1912 on Friday, especially if it is well below 1912, it is likely Bear Market Stage 5  would be underway and stock prices could fall precipitously until finding temporary support, likely near the 1865 level, at which level Long Straddles would become profitable, which Long Straddles often do immediately prior to a dead cat bounce for stock prices.

For a more in-depth look at the option strategies used in the above analysis, the following weekly 3-step analysis as provided.

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

Covered Call trading did not experience a single loss in 2013, and the streak endured until October 11, 2014, ending a streak of nearly lossless trading extending all the way back to late 2011. That means the Bulls were in control continuously for nearly 3 years. If the Bulls do not regain control over the coming week, the Bears could take over for several weeks, perhaps months or, in the most extreme scenario, years.

As long as the S&P returns to a level above 1912 over the upcoming week, Covered Call trading (and Naked Put trading) will return to profitability, indicating that the Bulls have regained control of the longer-term trend. Below S&P 1912 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. Two consecutive weeks with Bears in control is historically quite rare during healthy Bull-market corrections, but relatively common once a Bear market has begun.

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 on Long Call trading occurred in recent weeks for the first time in several months. Long Call trading became unprofitable this past March, Those losses intensified during April and early May before reverting back to profits for much of the summer. But the winning streak ended in mid-September. 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 below 2010, Long Calls (and Married Puts) will remain un-profitable, suggesting the Bulls lack confidence and strength. Above 2010, Long Calls and Married Puts will become profitable for the first time in several weeks, which would suggest a significant shift in sentiment, notably a huge return 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.

Long Straddle Trading

The LSSI currently stands at -1.9%, 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. Negative values for the LSSI represent losses for Long Straddle option trades. Small losses are quite normal and usual for Long Straddle trading.

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 2058 or below 1865. Values above S&P 2058 would suggest a continuation of the recent euphoric “lottery fever” type of mentality that tends to lead to a rally for stock prices. Values below 1865 would suggest an oversold market poised for a dead cat bounce.

Excessive Long Straddle trading profits (more than 4%) will not occur unless the S&P exceeds 2137 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 moves to very near 1940 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 1940 would likely bring a surprise rally or else a quick slip back into a continuation of the recent downtrend.

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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The following article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.

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