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.

Options Market Stages 2014-10-11

* 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):

Options Market Stages

Click on chart to enlarge

  • 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…)

By Poly

This is an excerpt from this weekend’s premium update from the The Financial Tap, which is dedicated to helping people learn to grow into successful investors by providing cycle research on multiple markets delivered twice weekly. Now offering monthly & quarterly subscriptions with 30 day refund. Promo code ZEN saves 10%.

The equity markets are finally seeing action that has even the most hardened bulls running scared. In the past, I’ve been quick to dismiss selling periods – Cycle Lows – as natural regression-to-the-mean events. In a bull market, an oscillating Cycle pattern of two steps forward and one step back is what drives an asset higher. But this time is different…two steps back is completely out of character. So much so, that I now believe that the 3.5 years bull market is now in serious trouble.

If we were to look for reasons to explain the recent selling, there are plenty to be had. The most likely is not a specific piece of news or single data point, but that the collective herd of market participants is fickle and can be easily spooked. The current bull market has broken plenty of records, including the length of time – more than 3 years – since a 10% correction. This has resulted in double-digit market gains for consecutive years, and a near vertical rise over a sustained period of time. Against the backdrop of a soft world economy, this performance is nothing short of remarkable.

What are potentially playing out are the very beginnings of a market turn. We could soon experience an environment of reversing psychology, where all tidbits of news will be construed as negative for the markets. It takes a lot of confidence (and ignorance) to elevate and sustain a market at present levels, especially one built on blind faith and the idea that the FED can keep the market elevated into perpetuity. This has bred a level of speculation, and arrogance, often seen at the top of longer dated Cycles.

If we need a catalyst for a potential market sell-off, we need only look toward Europe. Although the EU is just one market in the inter-connected global economy, it still makes up almost 25% of world GDP. And it’s large enough that any issues will send shock waves through world markets.

The EU’s problems are structural in nature, with too much government red tape, inefficient and constrictive regulations, and a labor policy that is not consistent with a rapidly-changing world economy. In addition, EU leaders have made poor choices of late. In particular was the instance on excessive austerity at precisely the wrong time in the Business Cycle. Austerity is choking what little life remains in the European economy, and is consuming capital needed to support investment and growth initiatives. The time to pay down debts and reign in spending is during good times; doing so gives the flexibility to loosen the reins and deficit spend during bad times. (more…)

By Jeff Pierce

As the market volatility increases and that is likely to continue for awhile let’s turn our attention to Bonds for clues. It’s entering an obvious area of resistance right now so it will be important to see how it trades between the $120-125 level.  I personally don’t think this has enough momentum to break out which could give the general markets a lift if this chart tops, but it’s to early to know that right now. It could just as easily continue moving higher but watch the RSI for clues as right now there is negative divergence as it won’t make a new RSI high if TLT makes new highs.

tlt

By Chris Ebert

Note to readers: The regular update of the S&P 500 options market will not be published this weekend due to the U.S. Columbus Day holiday. Regular updates will resume Sunday October 19, 2014.

The following chart may provide some perspective on the current state of the stock market. It’s definitely been a wild ride the past several days and weeks. But, overall the current sell-off is not too concerning considering it has not yet caused Covered Call trading to return a loss. Covered Calls opened at-the-money,4-months to expiration, are still profitable as the expire this week. Very often these trades are a harbinger of a Bear market, since they really only suffer losses when things have become truly bearish.

As long as Covered Call trading remains profitable, there is a possibility of major bounces higher for stock prices, as the nearly 300 point daily bounce for the Dow did this past Wednesday. It is conceivable that such a bounce could take stocks back to all-time highs. If, however, Covered Call trading becomes unprofitable (depicted by the red zone in the chart below) then chances are much greater that any bounce higher for stock prices would be a fleeting dead cat bounce. In that case it is conceivable that stock prices could fall considerably before finding support.

Options Market Stages 2014-10-11

The preceding is a post by Christopher Ebert, co-author of the popular option trading book “Show Me Your Options!” He uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. Questions about constructing a specific option trade, or option trading in general, may be entered in the comment section below, or emailed to OptionScientist@zentrader.ca

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