By Chris Ebert
The stock market is hot. There’s no denying it. Yet, it just doesn’t feel the same as it did a few months ago, or for most of the past several years for that matter. It’s like there is something missing.
Perhaps there truly is something missing – something big. It’s almost impossible to know for certain. It is possible to speculate as to the exact nature of what it is that is currently missing (big hands, little hands, hedge funds, HFTs, corporate fundamentals, QE, etc.) but the truth may never be known. The effects, on the other hand, are known.
Additionally, given the current effect on the stock market, it is possible to make some assumptions about the near-future for stock prices based on what has happened in the past. It doesn’t matter so much what exactly it is that is having the observed effect, if the end result is generally the same.
The end result of the current set of conditions in the options market has been for a Bear market in stocks to ensue within several weeks. In the past 12 years or more for which options data was obtained, the current condition of the stock market has always been followed by a major sell-off – a major decline in stock prices, not just a simple Bull-market correction – within as little as 4 to as many as 16 weeks.
When broad index ($SPY) at-the-money Covered Calls become unprofitable at expiration, as they did back on October 10, 2014, a full-blown Bear market has typically begun no more than a few months later. Viewed in this light, Covered Call losses mark the start of every Bear market. That means the current market is a Bear market, in spite of the fact that the S&P 500 is at all-time highs.
A Bear market does not mean that stock prices are headed straight down. In fact, it is not unusual for stock prices to hit all-time highs when a fresh new Bear market is underway. What it does imply is that something is missing – something big – and that whatever-it-is that is missing tends to have the eventual effect of driving stock prices far, far lower than those prices have been at any time in recent months, sometimes years.
* 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.
EXAMPLE: If Long Call premium paid is $2 when SPY is trading at $200, the loss is 1% if the option expires worthless.
You are here – Bear Market Stage 6 – the “Phew!” stage.
On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending November 15, 2014, this is how the trades (more…)