By Chris Ebert

The S&P 500 has hovered around the 2100 level quite a bit recently. That didn’t happen by chance; there’s a very good reason that level is so important right now. It represents a battle zone; and perhaps there is no better way to view that battle zone than by looking at some simple stock options.

Covered Call options generally only return losses in a Bear market. Of course, there are always exceptions to any rule. But, for the most part, a Covered Call* (*see specific description below) will always return a profit during a Bull market, and only return a loss during a Bear market.

S&P Can’t Loiter on Bull-Bear Border

no loitering allowedHere’s something to think about: If the S&P were to hover on the borderline between a Bull market and a Bear market, how long could it remain there? The answer is, not long. Not long at all.

The reason the S&P 500 cannot straddle the dividing line between a Bull and Bear market is that the moment stock prices would move in one way or the other, one side or the other would declare victory and the battle would be over. If stock prices rose, even slightly, the Bulls would declare victory and the victory party would send stock prices even higher, reinforcing that victory.

On the other hand, when the S&P 500 is straddling the line, the slightest dip in stock prices will be a victory for the Bears, and not only will the Bears send prices lower, the fear generated in the minds of the Bulls by such a victory will push many of them to sell their stock positions, in turn adding fuel to the sell-off.

Since the S&P 500 cannot straddle the Bull/Bear dividing line for any extended period of time, and since Covered Call profitability is one way of easily identifying the dividing line, then it stands to reason that the point of Covered Call profitability is a point that is unsustainable for the S&P 500.

Covered Calls are either profitable (and it is a Bull market) or they are not (and it is a Bear market). The S&P 500 rarely sticks around very long at the dividing line between Covered Call profit and loss. Thus, the S&P 500 (the white line in the chart) will rarely hug the red line on the chart. Generally, the S&P either bounces off the red line, or else it passes right thorough without stopping. But it almost never sticks around for a hug.

The dividing line between a Bull market and Bear market is usually not a place of protracted battles. Rather, long drawn out battles tend to take place inside one’s own territory. That’s the case at the moment, as the Bulls are engaged in a battle near the 2100 level for the S&P, well inside Bull-market territory.

Nobody Likes a “Correction”

Next, consider that for any Bear market, there is a zone just above it that is not quite bearish, but considered more of a correction. If Covered Calls are used to define a Bull and Bear market, then Covered Calls (which only return losses in a Bear market) must always be profitable in a Bull-market correction, by definition. Only when the correction becomes so severe that it morphs into a Bear market do Covered Calls suffer losses.

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While Covered Calls do return profits during a correction, it turns out that those profits are always less than the maximum possible profit on the trade. Covered Calls are a type of option trade in which profit is limited from the start. A Covered Call trade cannot exceed the maximum profit. During a healthy Bull market, Covered Call trading very often results in traders realizing the maximum profit on the trade. The only time a trader receives a profit that is not the maximum is when the market is undergoing a correction.

Nobody really likes a correction. Bulls certainly don’t like corrections unless they are looking to add to long positions. Even then, a Bull who adds to longs during a correction is always taking the risk that the correction is simply a precursor to a Bear market.

Bears don’t like corrections either. In most cases a Bear needs to wait around for solid signs of a Bear market before selling or shorting stocks. A correction does not fully meet all the criteria of a Bear market. To sell or go short during a correction can quickly lead to losses and short-covering when stocks find support and, having found support, start to rally higher.

The current stock market is one in which corrections are particularly troubling for traders to think about. That’s because there has been no major sustained correction for several years. Except for a sell-off that lasted only a few short weeks in October 2014, there really has been no pullback worthy of being called a correction since December 2012, nearly three years ago.risks ahead

Three years is a long time in the stock market. Having gone that long without a major Bull-market correction, many traders have lost their feel for dealing with one. Others still, especially newer traders, may never have dealt with a single correction in their entire career. As healthy as a correction can be, since it clears the air and often makes the outlook easier to see and interpret, a correction tends to cause stress for traders.

Since traders tend to avoid unnecessary stress, and since a correction tends to induce stress, a correction is often something the stock market avoids until there is no other alternative. A correction occurs when there is no way to stave it off any longer. This is true for Bears as well as Bulls. Bulls like Bull markets; Bears like Bear markets, but everybody avoids a correction, even those that tend to profit from it.

Traders Avoid a Correction Like the Plague

As mentioned previously, Covered Calls only experience losses in a Bear market and only experience maximum gain in a healthy Bull market. In between – in that zone known as a correction – is an area in which Covered Calls experience less than their maximum potential gain. Thus, since the market avoids corrections like the plague, it also avoids the zone in which Covered Calls experience less than their maximum profit. Essentially, the market avoids the orange zone on the chart if at all possible.

As can be seen on the chart, the orange zone occupies an area approximately 50 points wide. For most of July, August and September that zone exists between about 2050 and 2100 for the S&P 500 index. Thus, levels of the S&P between 2050 and 2100 are likely to be among the most avoided for at least the next three months.

bull bear dividing line1The Bulls don’t want to allow S&P levels between 2050 and 2100 because if it falls too far it will give the Bears an opportunity to attempt to bring on a Bear market. Thus, each time the S&P dips into that range, the Bulls will attempt to buy the dip, which will send the S&P back above that range.

The Bears certainly don’t want to allow the S&P to loiter in the 2050-2100 range either, because that range technically belongs to the Bulls. Even though that range represents a Bull-market correction, it is nonetheless still a Bull market. The Bears are only truly comfortable in a Bear market. Thus, each time the S&P dips into that range, Bears will be reluctant to sell or short stocks, knowing full well that they are outnumbered by Bulls. The Bears, therefore, are virtually powerless when the S&P is on the orange zone.

What the Bears really want is for the S&P to dip into the red zone – a Bear market – because that is where they are comfortable and confident. The only way for the S&P to dip into the red zone is for the Bulls to allow it to do so. The Bulls can’t really exert any influence until the battle is being fought on their own turf – inside the red zone.

Since the Bears can’t truly put up a fight until the S&P dips into the red zone, they are dependent upon the Bulls to get there on their own. There are only a few ways that can happen. Generally, the Bulls must experience a lack of morale. Something must make the Bulls give up hope. Often it’s a bit of bad economic headline-news. It could be employment numbers, housing, corporate earnings, or even an increase in interest rates.

The Only Way Bears can Win

If the Bulls get spooked enough, if they lose confidence, bad news can catch them off guard. Typically the Bulls will buy stocks as soon as the S&P enters the orange zone in the chart. However, if they are caught off guard, the S&P can dip into the red zone before the Bulls are able to react. Once the red zone has been entered, the Bears are bound to put up a fight.

Given the enormous length of time since the last Bear market – by the most generous standard the last one was in 2011 – the number of Bears waiting to pounce on an opportunity is likely now also enormous. The moment the S&P 500 enters the red zone, the war will intensify.

However, the war cannot and will not begin as long as the Bulls keep the S&P out of the red zone. That’s something they’ve become quite adept at doing, perhaps with a little help from outside sources keen on preventing a Bear market. Whatever the reason, the Bulls will do what they need to do to stop the next Bear market. As such, the prime directive is to defend the Orange Line of Violence.

As long as the Bulls don’t allow the Orange Line of Violence to be breached, the stock market will not be considered to be in a correction. If the market never enters a correction, it will never be in danger of entering a Bear market. If it never enters a Bear market, the Bulls won’t be forced to fight tooth and nail to get their Bull market back (like they did in October 2014). Thus, the command from the top from now until at least October is as follows for the Bulls:

  • Do not allow the S&P 500 to fall below 2100
  • If it does fall into the 2050-2100 range, bring it back above 2100 as quickly as possible
  • If it falls below 2050 get ready for war – a war we might not win

That’s a direct order!

* Covered Calls 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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