By Chris Ebert

Everyone knows the current Bull market is going to come to an end, but nobody can say exactly when, at least not with any degree of certainty. The best most of us can do is look at the signs as they appear.

The obvious signs of an approaching Bear market are huge sell-offs among wide baskets of stocks, such as those in the Dow, Nasdaq, and the S&P 500 indexes. However, a sell-off by itself does not make a Bear market, A prime example is the infamous 1987 Crash in which stock prices steadily rose in the months following the crash.

No, the end of a Bull market requires more than a decline in stock prices. It requires a decline in confidence.

OMS 04-17-15

 

* All profits are calculated at expiration, as a percentage of the underlying SPY share price. SPY is an Exchange Traded Fund (ETF), the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) that closely tracks the performance of the S&P 500 stock index. All options are at-the-money (ATM) when-opened 4 months (112 days) to expiration.
EXAMPLE: If Long Call premium paid is $2 when SPY is trading at $200, the loss is 1% if the option expires worthless.

The Options Market Stages are often good indicators of confidence.

  • Stage 1 (Lottery Fever) is the most confident, indeed over-confident
  • Stage 2 (Digesting Gains) is very confident, and often ideal for sustainability
  • Stage 3 (Resistance) is one in which confidence is waning
  • Stage 4 (Correction) is one in which the limits of confidence are tested
  • Stage 5 (Bear Market) is where confidence has been lost

Currently, the market has entered Stage 4. That doesn’t mean a Bear market is imminent, it just means traders should be vigilant. Confidence is being tested right now. Should that confidence fail, a Bear market would be the logical conclusion. However, the market has been very resilient lately, as evidenced by the remarkable recovery back in October 2014.

A major sell-off now, while the market is in Stage 4, could easily be followed by another major rally if substantial support appears and traders take that as a confidence booster. There is a trend over the past several years for confidence to be slowly evaporating from the market.

It was only a year or so ago when the market would enter Stage 1 Lottery Fever on a regular basis. Then in late 2014, Lottery Fever went away and has not returned. That, in and of itself is no big deal, since Lottery Fever is irrationally exuberant by nature, and therefore unsustainable over the long term.

bathtubsFor most of the end of 2014 and early 2015 the market managed to attain Stage 2 on a regular basis. Even in the absence of Lottery Fever, the ability to attain Stage 2 allowed the S&P to reach all-time record highs. However, since March 2015 the market has not been able to attain Stage 2. The best it could muster in the past couple of months is Stage 3.

The market may get along for many months without Stage 1, but it is unlikely the Bulls can survive for very long without Stage 2. That’s what makes the recent stretch of weeks without Stage 2 so terribly troubling. Confidence wanes during Stage 3. It may wane quickly, or it may wane slowly. But, every day that goes by makes folks a little less confident that the bygone days of all-time highs will return anytime soon.

Without the ability to attain Stage 2, the best prospects for the S&P 500 is that it will become a sideways chop fest. The best that can be hoped for is that there won’t be a massive 1987-style sell-off. While some may prefer a range-bound up-400-points-today down-400-points-tomorrow type of environment, many will be put off by such moves.

Whether the market manages to attain Stage 2 in the coming weeks remains to be seen. It is not something that can be predicted. It is, however, something traders can watch for. And, when they see it, they will know confidence has returned, and they will know what to do when they know other traders are feeling confident. In the meantime, there is not much to do but wait for the signpost to appear.

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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