By Chris Ebert
Rarely does a major stock market correction or a Bear market come as a complete surprise. Such events do not generally come as a bolt of lightning out of blue skies. Lightning almost always comes from storm clouds; and in the stock market those storm clouds come in the form of stock options. Options almost always provide an early warning.
Storm Clouds are Visible Early
Long before the Dow has started having 1000-point hiccups such as the one that occurred August 24, 2015, long before the VIX has rocketed off its lows, long before folks have started using the phrase: potential correction, long before all of that was a dark cloud hovering over the options market.
That’s good news for all traders. But for casual traders, retirement savers in 401k, IRA, RRSP plans and the like, the news is absolutely fabulous. To the casual trader who cannot or will not follow the day-to-day changes in the stock market, the storm clouds can be a life saver – allowing the saver to seek shelter long before a life’s savings gets destroyed by a stormy market.
The options market is very adept at signaling major changes in sentiment that precede a correction and which also precede a Bear market. Anyone can see and hear those changes approaching if they look and listen closely enough.
Not Everyone Hears the Thunder
The only problem – hundreds and thousands of so-called Perma-Bears (named for their seemingly permanent bearish attitude) are yelling “the sky is falling”. Thus, the signal from the options market, as reliable as it is, tends to get lost in all the noise.
The signal is very straightforward and it works on just about any individual stock or any basket of stocks, large or small, in any market around the world. For any expiring option opened 4-months to expiration with an at-the-money strike price:
Long Calls are only profitable in a Bull market
Covered Calls are only unprofitable in a Bear market
It is important to note that the terms Bull market and Bear market mean different things to different people. Here, Bull and Bear refer specifically to the primary or secondary trend – a trend lasting anywhere from a month or so to as much as a year or more. A primary or secondary trend is much shorter than a secular trend which can last five years to as much as twenty years or more. The above signals do not work reliably to identify secular trends.
Covered Calls are like Thunder
Here the concern is the near future. The options shown above are very good at identifying which trend is in place at the moment and therefore which trend is most likely to affect the near future for stock prices in the coming month and to some extent the coming year.
For much of the past seven years Covered Calls have been profitable using $SPX or $SPY options. Since $SPX and $SPY each track the S&P 500 index, the profitability of Covered Calls was an indication that a Bull market trend was in place in the S&P 500.
There were few instances in the recent past when Covered Calls became unprofitable: most notably in 2008 prior to the financial crisis, and in 2010 and 2011 prior to the mini-Bear markets in each of those years.
In each case, Covered Call losses preceded the majority of the bearish trend by several weeks to several months. All traders had plenty of warning – plenty of rumbling thunder. Perhaps most importantly, casual traders such as retirement savers had ample time to re-allocate portfolios to cash, money market funds or stable value funds before the storm reached full intensity.
For a full description of historical Covered Call profits and losses see “Option Market Stages – 10 Year History”
October 2014 Shot Across the Bow
A strange thing happened in October of 2014. Covered Calls suddenly began returning losses at expiration, but a Bear market did not immediately rear its ugly head. It was easy for many traders to ignore this important signal, particularly as stock prices subsequently climbed to some new all-time highs. It would have also been easy to lump the signal coming from the options in with all the Perma-Bears yelling “the sky is falling”.
Here is a chart of the Options Market Stages from late 2014 (note that it is not a typical Perma-Bear type of chart but instead leaves open a return to a Bull market if the S&P climbs above the orange line, which the S&P eventually did indeed accomplish)
To categorically discount the signal coming from the options (the sudden unprofitability of Covered Calls) is like ignoring thunder coming from distant clouds on an otherwise sunny day. The thunder is there to warn us; the losses on expiring Covered Calls are there to warn us, especially those of us who only follow the market casually.
Thunder doesn’t guarantee a storm will occur in any single location, but it does indicate the environment has changed. So too do losses on Covered Calls reflect a change in the environment. The more casual the trader’s connection with the market, the more important is that first rumble of thunder.
The shift in October 2014 was an important shift in the trading environment. It was a warning for folks to get prepared for a more bearish trend in the near future. Covered Call losses almost exclusively portend bearish trading environments, usually within a matter of weeks, occasionally within a matter of several months.
Since casual traders are less likely to be attuned to market changes than frequent traders, they may have missed the October 2014 event, which was a very important wake-up call – a storm was approaching. There was no guarantee the storm would make a direct hit, but there certainly was a storm approaching.
For further insight into the October 2014 event see Hitchhiker’s Guide to Bear Markets” which was published here during that event.
Second Warning in August 2015
On August 21, 2015 expiring Covered Calls again returned losses. Again this was a warning as loud as the thunder from a nearby storm cloud. It meant a bearish trading environment was near once again. Indeed it was only a few days later on August 24 that a major sell-off caused the S&P to decline 100 points and the Dow to decline 1000 points in a matter of a just a few minutes.
Not unexpectedly, the Perma-Bears rejoiced after the sell-off, as it bolstered the idea that they, and they alone, had been right all along. Once again the options were emitting a strong signal, but that signal was easily lost in all the noise. All the noise, noise, noise… noise!
Casual traders are perhaps more prone than others to have missed this important signal. The casual trader saw the news that the Dow fell 1000 points and was likely enticed to watch some TV financial news or do an Internet search, only to find thousands of Perma-Bears screaming “the sky is falling” and thousands of Perma-Bulls saying “the sky is most definitely not falling”.
In such situations, the casual trader often simply gives up, not knowing which to believe. In the process, the important signal tends to get lost in the noise – the casual trader neither sees the lightning flash nor hears the thunder rumble. But he could if he simply opened a window. That window is the Covered Call, analyzed and published here each week for anyone who cares to listen.
Below is the chart of the Options Market Stages as published here on August 20, 2015 just four days before the Black Monday event of August 24 (note that the chart here turned bearish on its own, regardless of the author’s opinion) Many Perma-Bear authors harbor a bearish bias, giving them an incentive to find a bearish chart, any chart, that supports their bearish opinion. Anyone can find a bearish-looking chart if they search for one. The chart below is updated week to week and consistently speaks for itself without bias – bullish in bullish times, bearish in bearish times.
Listen to the TV, read a financial newspaper, check the Internet, look at social media, and if the noise gets to be too much, check back here for a simple yet uncommonly consistent unbiased opinion that attempts to exclude the noise.
Third Time likely worse than August
Back in August the losses on Covered Calls initiated the start of what is known here as Bear Market Stage 5. While Stage 5 is a bearish environment, it generally comes with a major bullish bounce at the end.
That is to say, Bull Market Stage 5 is generally not the end of the world but merely a preview of what is to come further down the road, and it ends on a relatively nice note.
That bounce, commonly known as a dead-cat bounce, leads into an entirely new environment, Bear Market Stage 6 as it is known here. Bear Market Stage 6 is a rather odd stage. It features Covered Call profits.
Remember that Covered Call losses almost always signal an imminent Bear market – thus Covered Call profits might seemingly be considered to be a bullish sign. But referring back, it is Long Call profits that identify a Bull market not Covered Calls. Covered Call profits, with few exceptions, give nothing more than a false illusion of bullishness during Bear Market Stage 6.
For a complete description of Bear Market Stage 6 see “Welcome to Bear Market Stage 6”
Bear Market Stage 6 encompasses the entire area in which Covered Calls are profitable but Long Calls are not. Essentially it is a market with an illusion of bullishness but in reality the overall trend is to the downside. Bear Market Stage 6 therefore continues until either one of two things happen:
- Long Calls become profitable once again, the illusion of bullishness becomes a reality, and the bullish trend resumes
- Covered Calls become unprofitable once again, the illusion of bullishness disappears, and the bearish trend intensifies
Here is the most recent chart available for the Options Market Stages:
That’s where the market is right now – in Bear Market Stage 6. That is where it has been for several months, since approximately October of 2015. Until Long Calls become profitable or Covered Calls become unprofitable, that is where it will stay.
If Covered Calls become unprofitable now or in coming weeks it will be the third time in a little over a year. What had been a relatively rare occurrence (Covered Call losses) during the past several decades will have become rather common.
It will be like another bolt of lightning and another loud rumble of thunder. The storm clouds should then be apparent to anyone who cares to look. The options will then be blaring the alarm at full volume for anyone who cares to listen.
The signs will all be there. It will be the start of Bear Market Stage 7. The storm will be upon us then and it will be too late for many traders to take shelter. Particularly hard-hit will be the casual trader who failed to notice the building storm clouds and the intensifying lightning and thunder.
While the day trader and the swing trader and the position trader might also suffer a loss if a storm arrives now or in the next few weeks, the casual trader will be taken by surprise and could suffer catastrophic loss – that is unless he starts listening to the thunder and ignoring the noise.
Even if a casual trader finds other reliable sources of help, the thunder here is always worth a listen. It is worth repeating that thunder does not always guarantee a storm; no indicator is correct 100% of the time, including the Options Market Stages.
Weather Updates Now Available
For traders who prefer more frequent updates than the Options Market Stages provide, the S&P 500 Temperature may be of help. Each time the S&P 500 Temperature falls below zero it is like another bolt of lightning and another loud clap of thunder. The Temperature equals the distance of the S&P above the red line in the Options Market Stages chart. When the S&P 500 dives below the red line, into the red, purple or blue zones, the Temperature is a negative value. Above the red line, in the orange or black zones, the Temperature is a positive value.
As an example, here is the S&P 500 Temperature near mid-day January 15, 2016, though it recovered somewhat later in the day. Even so, it provided yet another loud clap of thunder. To receive updates of the Temperature on social media, traders may use the Follow Me On Twitter link 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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