August 21st, 2014
by Ask the Options Scientist
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Today's question: OptionScientist, do you have a chart of option performance going back several years? I would like to compare the current action to past stock-market corrections.
Answer: Long term charts can be difficult to read due to the high resolution required. But, the information they contain can be very valuable. Here is the chart of the Options Market Stages going back 10 years. A high-resolution version is available by clicking on the chart itself.
It should be noted that only the Bull Market Stages have been shown (for clarity). A Bear market, shown as the red zone on the chart, actually consists of several distinct stages (Stages 6 through 9).
Some quick observations:
- The S&P 500 almost never climbs above the green zone. The upper limit of the green zone, "lottery fever", represents a 4% profit on Long Straddle trades (% gain calculated as a % of underlying share price, not as a % of premium paid)
- A Bull market almost always resumes, no matter how steep the downturn in stock prices that caused the S&P has endured, unless it enters the red "Bear market" zone. The red line is thus the most important line on the chart, as it gives the most consistent signal with the fewest false signals.
- Other zones have varying degrees of accuracy, for example the blue zone "digesting gains" has some accuracy at predicting a brief pause (digestion) in an uptrend. The yellow zone "resistance" has a fair degree of accuracy at predicting a brick wall of resistance in the uptrend, sometimes a temporary brick wall, other times a relatively permanent one. The orange zone "correction" quite often predicts that a sell-off all the way to the red line is in store. But none of these stages is as consistently accurate as the red "Bear market stage". Getting out of long stock positions immediately upon S&P 500 entry into the red zone, and getting back into them upon S&P 500 exiting the red zone, is a simple system with a high expected rate of success.
For quick reference, the following table provides some general stock market conditions commonly found in each of the above Options Market Stages. A larger version is available by clicking on the table.