By Chris Ebert

Sometimes it can be helpful for a trader to step back for a few minutes and view the stock market from a different perspective – a perspective in which much of the ordinary noise is absent. While there is a place for up-to-the-minute news and charts of stock prices, there is also value in the quiet solitude of an option trader’s perspective.

This past week was unlike anything that has occurred in recent times in the stock market. The nearly-unprecedented decline in stock prices that sent the Dow Jones plummeting over 1000 points Monday (intraday) was followed by an equally amazing rally that more-than erased the entire loss by Friday.

It’s enough to make a trader’s head spin; and coupled with the economic news of the day it’s just too noisy for a trader to think clearly.

Options are much less noisy. Certainly option premiums are affected by the news, since volatility tends to cause premiums (in general) to rise. But, option trading is based on expectations of what the future holds for the stock market, not minute-by-minute changes in stock prices.

As such, options tend to be much more stable instruments than stocks – slower to react to changes in the market environment – making options reliable indicators even when the stock market goes wild, as it did this past week.

OMS 08-29-15 Bull

* 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)

Above is the chart of the Options Market Stages that is compiled and presented regularly here at zentrader. The chart uses the performance of some simple option trades* to determine the most likely trading environment currently present in the stock market as a whole. Whenever the S&P 500 enters the red zone on the chart, it is an indication of a potential Bear market. Bearish sentiment is likely to dominate when the S&P is in the red zone, regardless of whether the traditional threshold of a Bear market – a widespread 20% decline in stock prices – has been crossed.

Generally, the longer the S&P stays in the red zone, the greater the likelihood that a Bear market has begun. What’s more, once the Options Market Stages have indicated the presence of a potential Bear market, the analysis can also help differentiate a false alarm from a real one.

In October 2014 the Options Market Stages signaled a rare false alarm – a Bear market was indicated and it later turned out to be one of those rare false alarms. The S&P 500 went on to set new record highs in the months that followed that particular false alarm. Although such false alarms have only occurred a handful of times in the past 15 years, it is necessary to have a means of identifying a false alarm as soon as possible.

Once a trader recognizes a false Bear-market alarm, it tends to be relatively safe to re-enter long stock positions that are intended to be held for the moderate to long term (from several weeks to many months). On the other hand, if the Bear market alarm is indeed real, and not a false alarm, then it often behooves a trader to avoid long stock positions. Parking assets in cash, money market funds, or other instruments that are unlikely to be significantly harmed by a Bear market, can be prudent as long as the Options Market Stages are indicating a Bear market. Very often, the best opportunity to seek a safe shelter is during the first dead-cat bounce of a Bear market – an impressive rally off the lows, in which stock prices temporarily skyrocket higher only to plummet again afterward.

In order to identify false alarms, and differentiate those events from a true Bear market, the Options Market Stages chart shown above can be adapted to include additional Bear-market stages. While the above chart depicts everything in the red zone as a Bear market, the chart below separates the red zone into distinct bearish trading environments.

OMS 08-29-15 Bear

In the chart above, everything below the red line (the red zone, as well as the violet zone and blue zone) all encompass a Bear market. There is one major difference, though, from the previous chart. In this chart, the orange zone is also considered part of a Bear market, whereas in the previous chart it was considered part of a Bull market.

Although it can be a bit confusing to have one zone be part of a Bull market at times, and part of a Bear market at other times, a simple explanation can clear up any confusion.

During a healthy Bull market, stock prices may tumble from time to time. But, as long as Covered Call trading remains profitable (the orange zone or above, on either chart shown above) then it is likely still a Bull market regardless of tumbling stock prices. In a Bear market, rallies can be impressive, and some of those rallies can take the S&P into the orange zone. However, once a Bear market has taken hold for a few weeks, the mere presence of Covered Call profits (the orange zone) is no longer sufficient to declare a false alarm event.

Once a Bear market has its grips on traders and traders’ emotions, only a return to Long Call profits will erase traders’ fears of another major sell-off occurring. Thus, during a Bear market, only a bounce that takes the S&P 500 into the black zone on the above chart (the blue zone and the green zone on the previous chart) will erase traders’ fears. Failure to bounce to such a level will often result in fear remaining in the back of traders’ minds.

When traders are fearful, they tend to sell stocks when there is bad news. Thus, without Long Call profits, the fear just waits around for the next bad-news event. No matter how high the S&P rallies, unless Long Calls become profitable, the market is just living on borrowed time, waiting for the next bad-news event to act as a catalyst to drive stock prices considerably lower.

The following table depicts all of the different Options Market Stages. The textbook progression of the stages is also shown. A Bull market tends to progress from Stage 0 to 1, 2, 3, 4 and 5 and then back to 0. The process repeats indefinitely until at some point Bull Market Stage 5 fails to occur. That is when Bear Market Stage 5 begins (which is exactly what happened a couple of weeks ago). The Bear market then progresses from Stage 5 to 6, 7, 8 and 9 where it ends, leading to a new Bull market (a secular or secondary Bull market lasting months or years).

Options Market Stages

Click on chart to enlarge

Essentially, the current market is now a Bear market until Long Call profits prove otherwise. The current stage is Bear Market Stage 5 – the “Oh No!” stage. The next logical stage is Bear Market Stage 6 – the “Phew!” stage. The Phew! stage is perhaps more commonly known as the dead-cat bounce. Only a return to Bull Market Stage 0 – the “disappearing fear” stage can confirm (beyond a reasonable doubt) the resumption of the Bull market at this point in time. Anything less is just a dead-cat bounce. The chart below shows the typical progression of a Bear market.

Progression of Bear Market Options Stages 2015

Another way to think of the Options Market Stages is as the manifestation of the Elliott Wave theory. Whenever the Options Market Stages progress in a textbook manner, as depicted above, the resulting chart pattern of the S&P 500 should resemble an Elliott Wave. The chart below depicts the approximate position of the current S&P 500 level (You Are Here) on an Elliott Wave, in which the wave has been plotted with comparable timing to the Options Market Stages (i.e., each chart encompasses a time frame from as little as several months to as much as a year or more, in order for each form of analysis to identify moderate to long-term secondary and/or secular stock market trends).

Stocks and Options at a Glance 08-29-15

As far as option performance goes, it’s a Bear market until further notice. That doesn’t necessarily mean there can’t be impressive rallies, just that the overall trend is now to the downside. As can be seen on the charts of the S&P 500 versus the Options Market Stages, the S&P would currently need to climb to the 2130-2150 level or higher in order to provide convincing evidence that the Bull market had returned. Therefore, for at least the next several weeks, it’s a Bear market until the S&P tops 2130. Coincidentally, 2130 is the approximate level of the all-time record high for the S&P. So, it can be said that absent a new record high in the next few weeks, the S&P will likely remain in a Bear market.

* 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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 Related Options Posts:

Thursday Evening Options Brief 2015-Aug-20

Thursday Evening Options Brief 2015-Aug-13

Option Strategies for Range-Bound Markets

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