By Chris Ebert

There are three basic types of trading environments for the stock market:

  • Euphoria-driven trading
  • News-driven trading
  • Panic-driven trading

The “Rational” News-Driven Environment

newsThe news-driven environment is perhaps the easiest to comprehend. When it is in control, stock prices are somewhat correlated to the news of the day. Good economic news including good corporate earnings and fundamentals, good employment numbers, rising wages and a strong housing market tend to lead to rising stock prices. Poor news leads to falling prices for stocks.

The news-driven environment makes logical sense. Traders feel comfortable when there is a correlation between the news and stock prices. Often times the correlation is strong enough that causation can be observed – the news actually causes changes in stock prices.

Unfortunately, many a trader has learned the frustration that comes when the causation relationship breaks down. Even worse, traders are susceptible to huge losses, sometimes complete ruin, if they continue basing trades on a causal relationship between news and stock prices when that relationship no longer exists.

There are two ways the causation relationship can fall apart: euphoria can infect the market and cause traders to buy stocks while ignoring poor fundamentals, or fear and panic can overspread the market and cause traders to sell stocks regardless of great fundamentals.

Irrational Exuberance

During periods of euphoria, stock prices rise. The rising stock prices attract new buyers, in turn driving stock prices even higher and attracting even more buyers. It becomes a vicious cycle. Euphoria causes stock prices to rise much further and for longer periods of time than they would otherwise have risen if the stock prices had been based purely on fundamentals. Euphoria can cause Bull markets to far outlive what one might expect.

Frustration and anger are perfectly normal emotions for traders when they see stock prices rising in the face of poor or declining fundamentals. A trader may want to scream “Why are stock prices continuing to rise when the economy is clearly crumbling?” The answer is: euphoria.

When euphoria is underway, more traders are likely paying attention to rising stock prices than are paying attention to economic news. After all, if some bout of poor economic news is released and stock prices subsequently rise, the trader who recognized the euphoria and who purchased stocks is the trader who makes a profit. The trader who shorted stocks because of the bad news ends up with a loss, and likely some anger.

Euphoria is quite like the irrational exuberance that tends to surround lottery drawings, especially when the lottery jackpot is very high. Folks spend their hard-earned money buying tickets even though the odds of winning are astronomically low. It’s highly irrational, but people do it anyway, as if they are infected with a form of Lottery Fever.

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Lottery Fever occurs in the stock market just like it does with high-jackpot lottery drawings. It happens relatively often, actually, as can be seen from these recent bouts of Lottery Fever which occurred back in 2014. On the chart, Lottery Fever is assumed to have infected the stock market whenever a specific* Long Straddle option trade is profitable.

Irrational Fear (Panic)

In a similar but opposite manner, panic can overspread the market in as little as a few hours or a few days. When it does, fundamental analysis usually goes out the window. Fundamentals and the news of the day are often useless when fear and panic have taken over.

When traders are irrational, they don’t pay attention to the news – unless the news agrees with their already-irrational state. Good news is an excuse to buy stock during an episode Lottery Fever while bad news is ignored during a feverish state. But when panic strikes, bad news becomes an excuse to sell stocks while good news tends to be ignored.

A trader who buys stocks after a flurry of great economic news can go bankrupt watching stock prices tumble in the face of that good news. Not only can the trader lose a life’s savings, the frustration and anger are likely to skyrocket.

It is therefore of utmost importance for traders to recognize an irrational market whether it is irrational euphoria or irrational panic. Irrational euphoria occurs during Bull Market Stage 0, aptly named the Lottery Fever stage. Irrational panic occurs during Bear Market Stage 7 which is named the “Look out below” stage.

When Bear market Stage 7 is underway, traders are prone to panic. Few are paying attention to the news, unless it’s bad news. Good news does very little to boost a panicked trader’s confidence. Bad news simply fuels the panic.

OMS 12-18-15

While there is no way of pinpointing the start of panic exactly, there is a very high correlation with panic and the start of Bear Market Stage 7. Thus, it makes sense for a trader to recognize the start of Stage 7.

Bear Market Stage 7 only occurs after a major sell-off in stocks. But not every major sell-off results in Stage 7. To get to Bear Market Stage 7 requires two major sell-offs within a period of a few months, and with a major bounce higher in between the two sell-offs. The second selloff brings more panic than the first because of the “don’t fool me twice” attitude among traders.

In many cases, Bear Market Stage 7 occurs after a major “dead cat” bounce – a temporary yet impressive rally off the lows of the first major sell-off of a new downtrend. The second sell-off, which occurs after the dead cat bounce, can bring the panic of Stage 7 if it is severe enough.

As can be seen on the chart, the S&P 500 has already experienced one major sell-off in the past few months. It has also experienced a major rally (possibly a dead cat bounce). Therefore, the next major dip has the potential to be the start of Bear Market Stage 7.

Any dip into the red zone or below for the S&P 500 on the chart in the next few months would be considered Bear Market Stage 7. Any dip into the red zone would very likely correlate with the start of a panic. Panic has historically correlated with losses on a specific* option trade known as a Covered Call. The first time Covered Calls become unprofitable in a downtrend, the panic tends to be less severe (Bear Market Stage 5 on the chart). Then Bear Market Stage 6 ensues. Then the second time Covered Calls become unprofitable correlates with true unbridled panic; that’s Bear Market Stage 7.

A chart depicting the typical progression of a Bear market is available

Progression of Bear Market Options Stages 2015

Panic fuels selling, and selling fuels the panic. For that reason, Bear Market Stage 7 very often results in the steepest declines in stock prices of any part of the Bear market. That makes Stage 7 one of the most dangerous, especially for newer traders who may never have experienced such a steep decline.

Historical instances of Bear Market Stage 7 can be seen on a 10-year chart.

Bear Market Stage 7 is irrational by nature. A trader can easily become frustrated fighting the downtrend during Stage 7. Good news does not have the same effect during Stage 7 as it does in a rational environment. Traders who have become accustomed to trading the fundamentals successfully over the past several years should be prepared to abandon those fundamentals if Bear Market Stage 7 takes hold.

Bear Market Stage 7 has not yet occurred in 2015. Traders are therefore likely to still be somewhat rational at the moment. But if Stage 7 indeed begins, watch out below!

* Option strategies referenced above are analyzed for profit or loss on expiration day only and are opened using an at-the-money strike price, 4-months to expiration, using options traded on a broad-based ETF such as $SPY (NYSEARCA:SPY)

The preceding is a post by Christopher Ebert, Chief Options Strategist at Astrology Traders (which offers subscribers unique stock-trading perspectives and options education) and co-author of the popular option trading book “Show Me Your Options!” Chris 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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