Option Science: Stages of a Bull Market

October 1st, 2013
in contributors

by Chris Ebert, Zentrader

The market continues to show signs that it has entered Stage 4, which is known here as a Bull market correction. Unfortunately, Stage 4 is one of the most difficult stages to identify because it can only be confirmed in hindsight.


Follow up:

Stage 1 – the “lottery fever” stage – is obvious to almost everyone, without any analysis at all; just watch the evening news or read the newspaper headlines. Stock prices are rocketing higher, dips are short-lived and generally represent buying opportunities; and option traders are reaping profits on just about any bullish trade, whether it is a Covered Call, Naked Put, Long Call, Married Put, Long Straddle or Long Strangle. Stage 1 was clearly underway for most of 2013.

Stage 2 – the “digesting gains” stage – is also obvious; stock prices take a pause in the uptrend, but usually do not pull back far enough to pierce major support levels such as a 100-day simple moving average. Bullish option traders continue to profit on all but the most expensive option trades, particularly Long Straddles and Long Straddles which are inherently expensive.

Stocks and Options at a Glance

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 (NYSEARCA:SPY)

Stage 3 – the “resistance” stage – is easy to spot; Covered Calls and Naked Puts are the only simple Bullish option trades to return profits, as stock prices move sideways or pullback enough to pierce a major support level. At this point, recent highs in the S&P become written in stone, as was the case this past August with the 1710 level in the S&P. The market sure did its best to erase that 1710 record in September, after Stage 3 was in progress, but the Bulls were not strong enough to erase a record that was written in stone, at least not when considering the weekly closing level of the S&P.

Stage 4 – the “correction” stage – is very easy to see in hindsight. Very often, the S&P will test for support during an ordinary Bull market correction; and that level of support often coincides with the level at which the most conservative of all simple Bullish option trades, Covered Calls and Naked Puts, stop returning profits. Stock prices fall, bringing down the S&P to a point where Covered Calls stop making profits, and then the S&P bounces higher, resuming the Bull market. But, as previously mentioned, Stage 4 can only truly be identified when it has ended.

You Are Here – Bull Market Stage 4

Identifying Stage 4 can be difficult before Covered Call trading and Naked Put trading on the S&P have reached the profit and loss line; difficult, but not impossible. About 80% to 90% of the time, Stage 4 can be identified in advance by studying the performance of Long Straddle and Long Strangle trades.

When these trades return abnormally large losses, on the order of 6% over a 4-month period, it is an indication that Stage 4 has begun. Of course, an 80% – 90% accuracy rate implies that a Stage 4 correction will not materialize 10% to 20% of the time, but the odds definitely favor it.

Options Market Stages

Click on chart to enlarge

The reason that Long Straddle trading is a good indicator of Stage 4 is that excessive losses tend to occur only when the stock market has become stuck in a range for several months. That has certainly been the case recently, as the S&P has been bound between about 1600 and 1700 since late June.

Buy-and-hold investors have seen their holdings go nowhere since late June, so they can’t be blamed if they start selling those risky investments in exchange for a guaranteed return on lower risk or risk-free investments. Why keep funds parked in stocks that are earning nothing when those funds can earn a 1% guaranteed return elsewhere?

When the Long Straddle/Strangle Index (LSSI) reaches -6%, many long-term investors are likely to ask themselves that question. If enough investors choose to dump their stocks, simply because they have not experienced a profit for 4 months, that itself could be enough of a catalyst to bring about a full-fledged correction, even in the absence of any troubling economic news.

Preparing for What Will Happen Next

There are a few things to watch for in the upcoming weeks.

  • First, the Bulls have proven that they don’t have the strength to hold the S&P above that all-important 1710 level first achieved back in August. If they manage to gather enough strength to break that record and hold it, the argument for a correction would likely be off the table at that point.
  • Second, the Bulls have been in control of the trend continuously since late 2011. As long as the Bulls retain control of the trend, it would be evident by profitability on Covered Call option trades. Over the next several weeks, a level of about 1525 to 1575 represents the dividing line between Covered Call profits and losses. If a Bull market correction was to occur, that 1525-1575 range could potentially be tested.
  • Third, if the Bulls do lose control, it would be evident by losses on Covered Call trading. As such, any dip below the 1525-1575 range in the S&P in the next few weeks would be an ominous sign of the beginning 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.

Covered Call Trading

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 1565 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.

Long Call Trading

Long Call trading became profitable in February 2013 and remained profitable until August. Long Call trading is no longer returning profits, The break in that historically long streak of profitability marks an important shift in bullish confidence; the Bulls simply do not have the strength they did earlier in the year. This was evident in the recent failed attempt to break the 1710 weekly-close record on the S&P. Only if the S&P closes the upcoming week above 1688 will the Bulls will regain 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.

Long Straddle Trading

The LSSI currently stands at -3.7%, which is historically quite low. Such levels often precede a breakout of the S&P into a new trading range. 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. Since the market already attempted, and failed, to break out into a higher trading range above 1710 on the S&P, there is a possibility that the next break out could be to a lower range that tests for support in the 1525-1575 range. 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.

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