By Chris Ebert

It quickly becomes the goal of most every new trader to identify recurring patterns in the stock market. So long as the pattern truly repeats, the trader can learn to use the repeatability to his advantage.

By adjusting one’s trades to match a repeating pattern it is often possible to tip the scales so that the trades either have a greater than 50% chance of turning a profit or for the trades to return a much greater profit than would be expected in statistically neutral circumstances. The pattern can give a trader an edge that allows for positive expectancy – the trader can expect to have positive results over the long term even if some individual trades are failures.

Repeatable Option Patterns

The Options Market Stages were designed to give traders an edge. Although they are regularly featured here, the Options Market Stages only truly reveal their value when analyzed over a very long period of time, such as a decade or more. Such a wide time frame allows repeatable patterns to be observed – the very type of repeatability most traders crave.

Options Market Stages 10 year Bear 2006-2015

Click on chart to zoom to high-resolution version

As depicted on the chart, most Bear markets follow a very predictable pattern. By identifying the tell-tales signs of that pattern when the pattern is in its early stages, a trader can potentially avoid a great deal of the losses and pain that accompany stock ownership by moving assets into cash or other instruments and away from stocks and mutual funds. Other traders may actually position themselves to profit from declining stock prices, such as through short-selling of stocks or through options, for example.

Bear Market Stage 5

The pattern goes like this: A specific type of Covered Call* option that is almost always profitable during a Bull market (the black zone on the chart) suddenly becomes unprofitable. That is a shot across the bow, so to speak. When Covered Call options are not profitable, traders must consider that a Bear market is starting. This stage of the pattern is known as Bear Market Stage 5 (the red zone on the chart).

Bear Market Stage 5 is not 100% accurate at detecting Bear markets. No indicator is 100% accurate. That’s why traders need some sort of verification. When Bear Market Stage 5 is underway, the profitability of Long Straddle* option trades can serve as verification. Long Straddle profits are a signal that Bear Market Stage 5 has reached maturity (the purple zone on the chart).

Bear Market Stage 6

Even with Bear Market Stage 5 reaching maturity, a Bear market is not a guarantee. Once Stage 5 has reached maturity, there is very often a major bounce higher for stock prices. That bounce is commonly called a dead-cat bounce, so named because stock prices tend to bounce higher even if the Bull market uptrend is dead. The bounce very often brings Covered Call options back to profitability. This bounce is known as Bear Market Stage 6 (a return to the orange zone on the chart).

In a textbook progression of a Bear market, Stage 6 will only be temporary and stock prices will resume their downtrend within a matter of a few weeks to a few months.

Identifying False Alarms

false alarmOccasionally, however, the Bull market uptrend will resume immediately following Stage 6. When the uptrend does resume in such a manner, it serves as false alarm indicator – the repeatable textbook pattern is not underway. Every technical indicator requires a method of detecting false alarms. The false alarm then allows a trader to implement a fail-safe.

The fail-safe can be as simple as re-allocating assets back into stocks when a Bear-market false alarm is detected. Or it could be a warning to cover short stock positions – whatever action is likely to safely cause the least amount of regret when the pattern fails. Detecting the false alarm for the Options Market Stages is as simple as noting the return of Long Call* profits (the black zone on the chart).

Once a Bear market is underway, the S&P 500 should never enter the black zone on the chart. Long Call options should never occur in a textbook version of a Bear market; and Long Call options are only profitable in the black zone. Thus, the highest limit of a dead-cat bounce is to the lowest threshold of the black zone, no higher. If it does go higher then it likely is not a dead-cat bounce but rather a return to the bullish uptrend.

Bear Market Stage 7

Assuming the S&P does not cross into the black zone, the textbook progression of the Bear market pattern will lead into a major sell-off that causes Covered Calls to become unprofitable for a second time within a few months (the red zone on the chart, again). This second failure of Covered Calls is known as Bear Market Stage 7.

Once Stage 7 is verified, it almost always leads to sharp declines in stock prices. Those declines typically take stock prices more than 20% off their recent highs – the widely accepted definition of a Bear market is a decline of 20% or more off the highs. To verify Bear Market Stage 7 one need only look at the performance of Long Straddle* options. When Long Straddles become profitable, Bear Market Stage 7 has reached maturity (the purple zone on the chart).

Bear Market Stage 8

Once Stage 7 has reached maturity, it doesn’t usually take long for stocks to have a major sell-off. Such a sell-off takes the S&P low enough to meet the widely-accepted 20% definition of a Bear market. When this occurs, Long Straddle trades exhibit abnormal and extreme profitability (profit at expiration exceeds 4% of the underlying value). These extreme profits define Bear Market Stage 8 (the dark blue zone on the chart).

When Stage 8 has been achieved, the outlook for stock prices is very bleak. Stage 8 can last for weeks or months. To many traders it can seem as if Stage 8 will go on forever. There is seldom a light at the end of the tunnel.

Bear Market Stage 9

A strange thing happens though, once Stage 8 is underway. Option premiums tend to climb higher and higher as the outlook becomes bleaker and bleaker.

Eventually option premiums can become ridiculously inflated. When they do, it becomes possible for Covered Call traders to earn a profit. The profit comes as a result of exorbitant option premiums. The high premiums provide huge amounts of income for Covered Call sellers. The income can become so great that Covered Call sellers can earn a net profit from buying stocks and selling Call options, even as stock prices continue to broadly decline.

In a harsh Bear market the point at which Covered Call sellers become profitable is very important. That is the point at which traders can again buy stocks have a good chance at earning a profit, albeit a profit that requires option trading, but a profit nonetheless. The ability to buy stocks and earn a profit, regardless of how it’s done, serves as the light at the end of the tunnel. When Covered Call trading becomes profitable, it is a reliable sign of the end of the Bear market. It is known as Bear Market Stage 9 ( a final return to the orange zone on the chart).

Bull Market Stage 0

Bear Market Stage 9 typically comes with some major declines in stock prices. But once Stage 9 has been reached it generally only takes a few weeks for a fresh new Bull market to begin. When stock prices eventually rally high enough to cause Long Call option trades to become profitable, the Bear market is almost surely a thing of the past. Long Call profits almost exclusively occur in strong Bull markets. Those profits mark the start of Bull Market Stage 0 (the black zone on the chart).

Current Conditions

The current Options Market Stage is available in the Thursday Evening Options Brief along with an up-to-date analysis of the stock market from an option trader’s perspective. A complete description of all of the Stages as well as visual depictions are available in the Brief.

A current chart of the Options Market Stages is also available here.

* 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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