By Chris Ebert
This is either the beginning of the end for the recent 3-year uninterrupted run for the Bull Market and stock prices are headed much much lower; or it’s the end of a healthy Bull-market correction and stock prices are in a position to surpass their recent all-time highs within a few short weeks. The two scenarios are polar opposites. Now may be a good time for a trader to consider using option performance as an indicator of which path the stock market is on at the moment. Everyone can use options, even folks that don’t trade options, if for nothing other than a second opinion of where stocks are headed.
The S&P has currently finished Stage 4. That means it will soon enter Stage 5, perhaps as soon as this coming week. Another significant dip in prices without a recovery by week’s end suggests Bear Market Stage 5 has begun. The slightest rally in stock prices without losing ground by week’s end suggests the recent sell-off is done and the Bull market Stage 5 is on it’s way.
* All profits are calculated at expiration, as a percentage of the underlying SPY share price. SPY is an Exchange Traded Fund (ETF), the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) that closely tracks the performance of the S&P 500 stock index. All options are at-the-money (ATM) when-opened 4 months (112 days) to expiration. (e.g. Profit of $6 per share on an expiring Long Call would represent a 3% profit if $SPY was trading at $200, regardless of whether the call premium itself actually increased 50%, 100% or more)
You are here – Bull Market Stage 4 – the “Correction” Stage.
On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending October 11, 2014, this is how the trades performed on the S&P 500 index ($SPY or $SPX):
- Covered Call and Naked Put trading are each currently not profitable (A-).
This week’s loss was -0.5%.
- Long Call and Married Put trading are each currently not profitable (B-).
This week’s loss was -2.4%.
- Long Straddle and Strangle trading is currently not profitable (C-).
This week’s loss was -1.9%.
The combination A- B- C- would suggest the S&P 500 has entered a Bear market (Bear Market Stage 5) for the first time since November 2011. However, the Options Market Stages are intended as guidelines. They are not designed to be so rigid that a very small loss, for example the 0.5% loss for Covered Call trading, defines a Bear market.
This past week saw the S&P fall below the 1916 level – the level at which at-the-money 4-month-out Covered Call option trading became unprofitable. Normally, the unprofitability of those particular Covered Calls signals that a Bear market is underway; and it very well may be underway. But, 10 points (0.5% of the current S&P 500 level) is too small a margin to make such a bold statement with confidence, especially when considering the margin of error on calculating the profitability of such option trades. 20 points, maybe, but 10 is far too small.
Without confirmation – either by Covered Calls experiencing a second consecutive week of losses, or by Covered Call losses growing larger than 0.5% (larger than 10 points on the S&P) – it could prove to be a serious mistake to assume the Bull market has ended and a Bear market has begun. If the S&P remains below 1912 through the end of the upcoming week, especially if it closes below (more…)