By Chris Ebert

The following is a reply to a question from this option post - Breakout Is Right On Schedule

Question:

 Stage 4? With positive Covered calls? Doesn’t look close to stage 4, maybe barely stage 3. Please explain. Find this outlook interesting, but I don’t get this week…

Geoff,

I was hoping someone would ask this very question.

About 90% of the time, once Long Straddles experience losses of 6% during a Bull market, the S&P subsequently tests for support at a level where Covered Calls teeter on the brink of profits and losses.

The end of Stage 4 is easy to identify, because the S&P either bounces higher or falls drastically when it reaches the profit/loss line on Covered Call trading, thus marking the resumption or the end of a Bull market.

The beginning of Stage 4 is not as easy to identify, but about 90% of the time it starts when Long Straddles hit that -6% level.
Unfortunately, that means that 10% of the time the S&P will not sell off to the Covered Call profit/loss line as expected, but will instead bounce to new highs.

I am considering ways to avoid falsely identifying a Stage 4 correction, as was the case this time (so I understand your confusion this week). As always, any suggestions are appreciated.

Perhaps Stage 4 needs some sort of confirmation, such as waiting a week or two after Long Straddles have reached the -6% level in order to make sure the breakout is not going to be to new highs.

It is interesting to note that this is the first time in several years that Stage 4 did not materialize as would be expected. One could speculate as to the reasons that it fails 10% of the time. It is possible that an LSSI of -6% represents a sweet spot for carefully-timed news releases. Thus, while the market is allowed to correct naturally 90% of the time, the other 10% of the time presents an opportunity to release news (Syria, Unemployment Glitch, Yellen, Taper, etc.) and get a bigger pop in the market than would have been possible if the LSSI was not at -6%. Sort of like pushing a child on a swing, it is not necessary to give a push on every back-swing, but that 10% of the time that a push is necessary, doing so when the child is momentarily motionless in mid-air adds the most momentum with smallest effort.

Questions, comments and constructive criticism are always welcome. Enter them in the comment box below, or send them to OptionScientist@zentrader.ca

The preceding is a post by Christopher Ebert, who uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. He studies options daily, trades options almost exclusively, and enjoys sharing his experiences. He recently co-published the book “Show Me Your Options!”

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One Response to “Stage 4 Did Not Materialize As Expected”

  1. Danny Says:

    I was also surprised how shallow the “correction” has been. A Nasdaq close above 3730 was my line in the sand, and now the market has surged above it.
    I think market will either go up or down a lot from here, so this could be a good time to buy some straddles..

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