Welcome To Bull Market Stage 2

June 24th, 2013
in contributors, syndication

by Chris Ebert, Zentrader

Stocks and Options at a Glance

This past week marked an important change in the stock market. While many eyes were on the Fed, and on the subsequent 350 point plunge in the Dow, there was also an event affecting option traders that deserves attention.

Long Straddle* trading ended its 16-week winning streak this past week – the second longest winning streak in the past 10 years. That is important for all traders, not just those who trade options. It is an important change because Long Straddle trading is rarely profitable. Profits represent surprise – in this case option traders failed to anticipate how high and how fast stock prices would climb, and were surprised by the outcome.

When prices rise faster than anticipated, traders on the sidelines are enticed to join the party, much the same way that a large lottery jackpot attracts ticket buyers. When Long Straddle trading is profitable in an uptrend, it is an indication of “lottery fever”.

Follow up:

The lottery fever stage, labeled below as “Bull Market Stage 1”, appears to be over for now. It has been replaced by Bull Market Stage 2 – the “digesting gains” stage.

Click to enlarge

[NOTE: *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

Click Here for a complete chart of all Options Market Stages

Bull Market Stage 2 represents a market in which traders are pausing to re-evaluate stock prices. It is a normal and often healthy part of any stock market cycle.

At one point this past May, stock prices had risen so quickly that major indices such as the Dow, S&P and Nasdaq saw gains approaching 20% for the year to date. It is difficult to rationalize a reason to sell when prices are rising so quickly. When bad news caused a dip in prices, buyers saw it as an opportunity to rush in, driving prices back up in the process. That’s how lottery fever works. Bad employment numbers – buy the dip; disappointing earnings – buy the dip.

Now that the market has progressed to Stage 2, the “digesting gains” stage, traders can take a moment to consider whether stock prices are realistic. While it wasn’t necessary to give too much consideration to economic outlooks and company fundamentals back in Stage 1, since prices seemingly had nowhere to go but up at that time, traders now have an opportunity to evaluate those factors without the distractions of a go-go-go stock market.

In some ways the stock market is similar to auto racing. Often there will come a time when drivers are running low on fuel and all four tires are wearing thin. But nobody wants to be the first to leave the pack and pull into the pits. A yellow flag can provide a much needed opportunity for maintenance, without the risk of missing out on headway that would otherwise occur under a green flag. If Stage 1 is like the green flag, then Stage 2 is analogous to the yellow flag.

What Happens After Stage 2?

The above chart is a textbook model of how the stock market tends to perform. Of course, there are occasions when the market does not fit the model. An example would be for stocks to suddenly rally back to recent highs, which would be a resumption of Stage 1. What would be expected by the model would be for the market not to revert to Stage 1, but to eventually progress to Stage 3 – the “resistance stage”.

At stage 2, Long Straddle trading became unprofitable. At Stage 3 Long Call trading joins the list of unprofitable option strategies. The change tends to coincide with a change in sentiment, such that recent market highs become strong resistance levels, hence the name “resistance stage”.

To reach the resistance stage, stocks generally either need to trade sideways or downward. If the S&P remains below 1594 through the end of next week (ending June 29, 2013) that would indicate the beginning of stage 3. At that point, Long Call trading would become unprofitable and it would become quite likely that the record highs of May would then represent a significant resistance level.

Many traders who entered the market at the highs and held on until Stage 3 would be likely to become so anxious that they would gladly dump their shares at break-even. That means there would then be a lot of sellers if the market re-visited those highs, which would make it difficult for the major stock indices to exceed those highs; it would be a classic display of resistance. Most of the time, once the market has reached Stage 3 it does not immediately test the resistance level, but first seeks out a support level. The process of seeking support is what leads to a Bull market correction.

Beyond the resistance stage is usually Stage 4 – the “correction stage”. At this stage Covered Call trading becomes unprofitable, along with continued unprofitability of  Long Call trading and Long Straddle trading. Currently, Stage 4 would be indicated if the S&P was to fall to a level near 1508 in the upcoming week.

Is This the Start of a Bear Market?

A close look at the chart above reveals that the beginning stages of a Bear market are the same as those of a Bull market. It is difficult, perhaps impossible, to know the difference in advance. What determines the difference many times is whether stock prices bounce higher after reaching Stage 4, or whether they continue lower.

If the S&P was to fall much below 1508 in the upcoming week (ending June 29), without a subsequent bounce, that would be a strong argument that it was more than a temporary correction and quite possibly confirmation of a Bear market. However, a bounce higher would be a signal that the market had simply experienced a temporary correction in a longer-term Bull 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.

Click to enlarge

This week, Covered Call trading and Naked Put trading were both profitable, as they have been for an extended period. That means the Bulls remain in control. 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

This week, Long Call trading and Married Put trading were both profitable, but not nearly as profitable as in recent weeks and months. Both forms of trading became profitable in late January, indicating that the Bulls were not only in control, but also confident and strong.

The recent sell-off has decreased the confidence of the Bulls, so much so that if the S&P remains below 1594 through the upcoming week (ending June 29), any remaining confidence will disappear. Below S&P 1594, previously profitable Long Call trading will become unprofitable, which is often a sign of a lack of Bullish 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

Long Straddle trading and Long Strangle trading became profitable on March 1, 2013. That marked the beginning of a surprising uptrend in stock prices. The profits continued uninterrupted for 16 weeks, the second longest winning streak in the past 10 years before finally returning to losses this week ending June 22, 2013.

While the recent pullback in stock prices does not yet meet the criteria of a typical Bull market correction, it is quite possible that a correction may still occur. An elevated LSSI has always led to a correction in the past, and there’s no reason to suspect this time will be an exception. It’s just a matter of how long until it occurs. 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.

[NOTE: *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.

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