By Chris Ebert

There is an often overlooked cycle in the stock market that deserves some extra attention these days. Stock prices often experience periods of movement punctuated by periods of stagnation or consolidation. In other words, sometimes stock prices are in a trend and other times they move sideways and make no progress. The alternating periods of consolidation and trend form a repeating cycle of range-bound prices and break-outs.

The cycle can be difficult to discern for traders, but it is especially tough for new traders. That’s because stock prices move every day, and sometimes the moves are big even when there is no overall trend.

Take this past week, for example, when the Dow Jones rose 235 points in a single day on Wednesday. Even with such a violent move, the Dow itself is not really in a trend. That’s because despite recent big moves, the Dow was relatively unchanged for the week. It also has not made much progress for the month of June, or for the year 2015 to date. There simply is no trend right now; the stock market is remarkably range bound.

Range-bound Markets Lead to Breakouts

Range-bound markets often get violent. When neither the Bulls nor the Bears has the ability to make any sustained progress, each group gets more bold. That’s because the inability to make progress has the effect of limiting the risk for each. If a Bull buys stock in a tightly range-bound market, the chances are low that the Bears will be able to drive the price down for any sustained period of time. At the same time, a Bear can sell or short stock knowing that the Bulls are not likely to drive prices sustainably higher. Each ends up spinning his tires at full throttle.

The effect of spinning the tires at full throttle is evident with the huge intraday moves in stock prices that are often observed near the Orange Line of Violence on a chart of the Options Market Stages.

OMS 06-11-15

Spinning the tires at full throttle doesn’t result in any progress as long as there is no traction. However, once the stock market has entered this scenario, the slightest bit of traction has the ability to send stock prices flying. Which direction stock prices will go depends on many factors, including the type of economic news catalyst that provides the traction, and the whether the timing of that news comes when the tires are spinning forward or in reverse.

A great bit of news when the Bulls are pushing for a breakout can sometimes be enough to break through a brick wall of resistance and send stock prices to new highs. On the other hand, even the greatest news may have no effect on stock prices if it comes on a day when the Bears are intent on selling.

Likewise, bad news on a day when the Bears are already in control can be enough to spur a break below major support levels. While this is true anytime, the effect is often magnified by the effect of the range-bound market – the tires are already spinning at full throttle when the news is released.

Options Indicate Breakout Potential

There are a number of ways to spot a range-bound market that is primed to break out. While chart patterns are typically good ways to spot it, a study of options known as the S&P 500 Long Straddle Strangle Index (#LSSI) is also well suited for this purpose.

LSSI 06-11-15

When the #LSSI is extremely low, particularly -6% or lower, the S&P 500 tends to be extremely range-bound, and thus due for a breakout. This past week, the #LSSI reached -6.3%, so it would seem that the S&P 500 is now spinning its tires at full throttle. All it needs now is a little traction.

Chart Patterns Suggest Breakout Directionality

Typical chart patterns of consolidation or range-bound prices include triangle patterns such as the Flag (though technically more of a trapezoid than a triangle) and the Pennant. In both the Flag and the Pennant the throttle is being opened wider and wider as time passes, and the tires are spinning faster and faster, and very often the stock takes off violently in the original direction of travel when traction is eventually gained.flag and pennant

When the #LSSI is extremely low, a Flag or a Pennant can be an indication that the S&P 500 is about to take off and resume the overall trend. Currently, the overall bullish trend is still intact, so a Flag or a Pennant now would be a strong signal for the Bulls.

In another type of triangular formation, known as a broadening formation, the scenario can be entirely different than a Flag or a Pennant. In the broadening formation, the tires are not spinning freely, but rather gaining more and more traction with each move forward and back. A broadening formation does not require a news catalyst for traction – there is no lack of traction.

broadening formationWhen a broadening formation is present, eventually the traction will allow the stock price to move too far one way or the other, forcing one side to surrender and capitulate. Whatever the trend was prior to the broadening formation, the swings in price often get too wide for those following the trend causing them to abandon their positions, in turn causing a reversal of the trend when too many trend followers abandon their positions at once.

When the #LSSI is extremely low, a broadening formation in the S&P 500 could be a strong signal of an upcoming reversal of the overall trend. Broadening formations in the current bullish trend could spell a major sell-off in the S&P, particularly now when the #LSSI is definitely at extremely low historical levels.

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

twitter

Related Options Posts:

Thursday Evening Options Brief 2015-06-11

#1 Stock Market Concern this Memorial Day

Thursday Evening Options Brief 2015-05-21

 

Leave a Reply

You must be logged in to post a comment.