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Easily Spot Digestion, Correction, Bear Markets

By Chris Ebert

It wasn't all that long ago that major U.S. stock indices, such as the Dow, NASDAQ and S&P 500, soared following the release of some truly surprising economic news. That news was that the U.S. economy had created a dismal 75,000 jobs in December while most experts were expecting 200,000 or more. Jobs failed, yet stocks soared.

Now, just two weeks later, disappointing news out of China seems to have frightened everyone. Then there is this thing called "the taper", which suddenly has everyone's attention despite the fact that the Fed announced its plans many months ago, and clarified its plans several weeks ago, all in an effort to prepare the world for the difference between $85 billion and $75 billion in monthly bond purchases.

Maybe the change in traders' reactions to economic news in recent weeks - buying stocks in the face of surprisingly poor data one week, and selling stocks in the face of not-so-surprising data a few weeks later - is a signal of a fundamental shift in the health of economies around the world. Maybe the stock market is simply performing differently because the economic picture is not as rosy as it was several weeks ago. Maybe the taper has changed everything.

Or, maybe, just maybe, the stock market is simply reacting to itself - in other words, going through a natural cycle of euphoria and despondency in which poor economic news is more of an effect of the recent sell-off rather than the cause. If so, then recent doomsday economic headlines are just the effect of a natural downturn in the stock market cycle, in much the same way as the popularity of phrases such as "polar vortex" and "arctic assault" in North America is the effect of a normal climate cycle widely-known as this: a cold winter.

No cold winter: No attention to the circumpolar vortex.

No stock cycle downturn: No attention to poor economic news.

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*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)

Assuming that the recent sell-off in the stock market is nothing more than part of a natural downturn in the stock market cycle, great insight can be gained by studying the cause of the downturn. It is important to note that the stock market environment has shifted this week - from Bull Market Stage 1 "lottery fever" to Bull Market Stage 2 "digesting gains". It is also important to recognize why the shift occurred. The following in-depth analysis explores the cause of the shiftand its prognosis.

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 3.7%.
  • Long Call trading is currently profitable (B+). This week's profit was 2.4%.
  • Long Straddle trading is not currently profitable (C-). This week's loss was 1.2%.

The combination, A+ B+ C-, occurs whenever the stock market environment is at Stage 2. As can be seen on the chart, Stage 2 is not necessarily the end of the world. For example, even if the market was to follow a natural progression downward to Stage 3 and Stage 4, as long as Stage 5 results in a bounce higher for the S&P, the downturn itself is not a major long-term concern. Often times, Stage 2 is nothing more than a healthy digestion of the market's recent gains. Other times it represents the middle of a larger correction. Every once in a while it represents the beginning of a Bear market.

So, which one is the current Stage 2? Simple digestion, part of a correction, or the start of Bear market? Anyone can guess, but even an educated guess is still just a guess. The important thing is being able to recognize which one when enough data finally becomes available, and it will become available. A trader who is able to prepare for each scenario, and act quickly when the market reveals which scenario is actually going to play out, has an edge over other traders who are not prepared.

When developing an edge, it is helpful to put the recent sell-off in perspective. It is interesting to consider that Covered Calls are currently profitable, which is bullish; Long Calls are also profitable, which is very bullish; and Long Straddles are no longer profitable, but those things rarely profit anyway. In addition, the very same scenario occurred fairly recently, in June of 2013 and again in August; each without much long-term effect on the Bull market.

The "end of the world" scenario is evident only if the S&P fails to bounce higher at Stage 5, failing to resume the Bull market trend, and instead sinks lower at Stage 5 into a true Bear market. Which one will occur? Again, anybody's guess. Recognizing it once it has already occurred, and being prepared to trade based upon that recognition is what allows traders to gain an edge over those who do not recognize it and thus are not prepared to benefit. The following chart has been presented here many times in the past, but its explanation of a typical stock market cycle remains true today. This is how to recognize where the stock market is at any point in time.

(click to enlarge)Click to enlargeClick on chart to enlarge

What Happens Next?

Before looking to the future of the stock market, it is important to understand how we got to where we are. A few weeks back, the S&P exceeded the green line on the chart below. That green line represents an unsustainable uptrend in stock prices. Being unsustainable, such a level is often followed by a pullback in stock prices, and sometimes that pullback is strong enough to be considered a correction.

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To see the full Options Market Analysis at the time the S&P exceeded the green line, click here.

That green line is important because it represents the level at which profits on Long Straddle option trades on the S&P 500 become absurd, in excess of 4% profit in 4 months. Historically these absurd profits have signaled a market in which euphoria has gone awry; and historically the market has quickly put an end to such absurd profits very quickly.

One can see that there are several ways to put an end to excessive Long Straddle profits:

  • The S&P can continue to rise, but at a slow-enough pace to bring it below the green line.
  • The S&P can drift sideways for several weeks until it is below the green line.
  • The S&P can quickly pull back or correct until it is below the green line.

Obviously, the current market has chosen the third alternative and has pulled back quickly. Thus, the market is no longer overbought, at least not by most definitions of the word overbought. The question now is whether the recent sell-off was enough or whether it is just the tip of the iceberg - after all, a traditional Bull market correction could pull the S&P all the way down to the red line.

Predicting whether the market is done selling-off is not what the Option Market Stages are about. Instead, they are presented to help traders recognize future emotions, thereby giving readers an edge in the market. Gaining an edge means being prepared, so here is what to be prepared for during the last week of January.

  • If the S&P closes the week above 1821 (blue line), Long Straddle trading will return to profitability, indicating a return to lottery-fever-type bullishness.
  • If the S&P remains between 1762 (yellow) and 1821 (blue), Long Call trading will remain profitable, indicating the Bull market is intact but is in the process of digesting recent gains.
  • If the S&P falls below 1821 (yellow), Long Call trading will no longer be profitable, indicating a loss of Bullish strength and causing recent S&P highs to take on brick-wall resistance properties in the future.
  • If the S&P falls to 1719 (orange), Long Straddle trading will experience historically-extreme losses of 6% or more, often associated with subsequent major breakouts in which the S&P soars towards new highs or else sinks well below its trading range of the prior several months.
  • If the S&P falls to the red line (currently at 1644), Covered Call trading will fail to return a profit. Historically, a bounce higher from this level is an "all clear" signal that the sell-off is over and the Bull market has resumed, while failure to maintain this level is a serious sign that a Bear market underway

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.

(click to enlarge)Click to enlarge

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 today. As long as the S&P remains above 1644 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.

(click to enlarge)Click to enlarge

Long Call trading was profitable for almost all of 2013 except for a brief break from August through early October, and remains profitable today. As long as Long Call trading remains profitable, the Bulls will retain confidence and strength. That very confidence is what allowed so many new records to be set for the S&P in 2013. Only if the S&P closes the upcoming week below 1762 will Long Calls (and Married Puts) 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.

(click to enlarge)Click to enlarge

The LSSI currently stands at -1.2%, which is within normal limits. Profits on Long Straddle trades will not occur this week unless the S&P exceeds 1821. Anything higher indicates the presence of euphoria, often accompanied by lottery-fever-type bullishness.

Excessive profits on Long Straddle trades, such as those exceeding 4%, will not occur this coming week unless the S&P rises above 1889. Despite the presence of euphoria, anything higher than that is likely to result in some selling pressure, and historically has been associated with subsequent pullbacks and, occasionally, Bull-market corrections. Even if the LSSI does not exceed +4.0% this coming week, the fact that the LSSI recently exceeded +4% a few weeks ago makes some sort of pullback or a correction a distinct possibility for the next several weeks, although that possibility tends to decrease as time passes.

Excessive losses on Long Straddle trades, such as those exceeding 6% will not occur this coming week unless the S&P falls to 1719. At or near that level a subsequent breakout is likely. 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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