By Chris Ebert

The stock market is hot. There’s no denying it. Yet, it just doesn’t feel the same as it did a few months ago, or for most of the past several years for that matter. It’s like there is something missing.

SNP Temperature 11-11-14Perhaps there truly is something missing – something big. It’s almost impossible to know for certain. It is possible to speculate as to the exact nature of what it is that is currently missing (big hands, little hands, hedge funds, HFTs, corporate fundamentals, QE, etc.) but the truth may never be known. The effects, on the other hand, are known.

Additionally, given the current effect on the stock market, it is possible to make some assumptions about the near-future for stock prices based on what has happened in the past. It doesn’t matter so much what exactly it is that is having the observed effect, if the end result is generally the same.

The end result of the current set of conditions in the options market has been for a Bear market in stocks to ensue within several weeks. In the past 12 years or more for which options data was obtained, the current condition of the stock market has always been followed by a major sell-off – a major decline in stock prices, not just a simple Bull-market correction – within as little as 4 to as many as 16 weeks.

When broad index ($SPY) at-the-money Covered Calls become unprofitable at expiration, as they did back on October 10, 2014, a full-blown Bear market has typically begun no more than a few months later. Viewed in this light, Covered Call losses mark the start of every Bear market. That means the current market is a Bear market, in spite of the fact that the S&P 500 is at all-time highs.

A Bear market does not mean that stock prices are headed straight down. In fact, it is not unusual for stock prices to hit all-time highs when a fresh new Bear market is underway. What it does imply is that something is missing – something big – and that whatever-it-is that is missing tends to have the eventual effect of driving stock prices far, far lower than those prices have been at any time in recent months, sometimes years.

Stocks and Options at a Glance 11-15-14

* 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.

You are here – Bear Market Stage 6 – the “Phew!” stage.

On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending November 15, 2014, this is how the trades performed on the S&P 500 index ($SPY or $SPX):

  • Covered Call and Naked Put trading are each currently profitable (A+).
    This week’s profit was +2.5%.
  • Long Call and Married Put trading are each currently not profitable (B-).
    This week’s loss was -0.0%.
  • Long Straddle and Strangle trading is currently not profitable (C-).
    This week’s loss was -2.5%.
Options Market Stages

Click on chart to enlarge

The combination A+ B- C- occurs whenever the stock market is at Bear Market Stage 6, the “Phew!” stage, which gets its name from the collective sigh of relief from stock owners during the first dead-cat bounce higher for stock prices which occurs immediately after the first major sell-off of a new Bear market.

The combination A+ B- C- also occurs at three other stages: Bull Market Stage 3 “resistance” which only occurs during a minor pullback in an otherwise roaring Bull market, Bull market Stage 5 “all clear” which occurs after a healthy Bull market correction, and Bear Market Stage 9 “bargain” which only occurs after a mature Bear market has neared its bottom. None of those other stages is applicable today, with the possible exception of Stage 5, which is improbable yet possible and therefore requires attention.

Bull Market Stage 3 only follows Stage 1 (which is so bullish that Long Straddles are profitable) and Stage 2 (which is moderately bullish, so that Long Calls are profitable). Neither of those types of trades has been profitable for several weeks. This is clearly not Bull Market Stage 3.

Bear Market Stage 9 only follows Stage 7 (Stage 7 is so extremely bearish that Long Straddles are profitable) and Stage 8 (which is ridiculously bearish, so that Long Straddles are extremely profitable). Neither of those has occurred recently; Long Straddles have not been profitable. This is clearly not Bear Market Stage 9.

Bull Market Stage 5 only follows Stage 4 (in which a healthy correction either does not become so severe that Covered Call trading turns unprofitable, or else Covered Call losses are insignificant). Since Covered Call trading has recently suffered two consecutive weeks of significant losses, it is improbable that this is Bull Market Stage 5, yet not entirely impossible.

What’s Missing?

In last week’s update the focus was on the role of the master manipulator. Large participants in the stock market, be they individuals or institutions, can have an effect on stock prices simply due to the influence of moving their large positions. When they buy, they drive stock prices higher. When they sell, they push prices lower.

In a healthy Bull market, historically, large position holders – master stock-price manipulators – have typically not sold such a large quantity of stock at any given time that they drive stock prices down so far, so fast, that Covered Calls fail to profit.

It takes a mighty big sell-off to bring upon Covered Call losses. That’s because Covered Call trading relies on the collection of option premiums as income. The income from the Calls offsets losses incurred on the stock. Generally. the more bullish the stock market, the lower the premium; the lower the premium, the more sensitive Covered Call trading becomes to decreasing stock prices, such as a decrease caused by the dumping of large volumes of shares.

Generally, when the VIX is very low, Covered Call performance becomes very sensitive to folks dumping large stock positions. When the VIX is very low, it’s also a time that one might not expect large positions of stocks to be dumped. Covered Calls therefore become most sensitive to the dumping of large volumes of shares when the timing of the dump is at its most suspicious point. That makes them a very effective indicator. What does the dumper know that the rest of us don’t?

The expiration date of the option is a factor, but not as large a factor as might be expected. Weekly options, for example, have much lower premiums than options with monthly expiration. The lower the premium, the less the offset will be if there is a loss on the stock. But, the shorter expiration of a weekly option also leaves less time for such a loss to occur when compared to a monthly expiration.

Even though the choice of expiration date is not of utmost importance, for consistency all the options referenced in this analysis are 4-month expirations (opened 112 days prior to the expiration date of the option). Also, for consistency, all strike prices are exactly at-the-money at the time the options are opened.

When someone, anyone, or any entity large enough to be able to dump shares of stock on the market in such quantity and such speed that the share price falls considerably, it is noteworthy. When the size and speed becomes so great that Covered Calls become un-profitable, it isn’t just noteworthy, it’s newsworthy. When Covered Calls become unprofitable, it almost always marks the start of a new Bear market because it marks the exit of large participants in the stock market. That’s what’s missing! The large participants!

All-time Highs in a Bear Market?

Taking away a negative is often quite similar to adding a positive. In fact, in mathematics there is no distinction between addition and subtracting a negative. For example, 1 + 1 = 2 and 1 – (-1) = 2. In the stock market, the sudden disappearance of selling pressure can have a very similar effect to the addition of buying pressure.

When a large position in stock is liquidated, the sale of the shares of stock often sends the share price tumbling, at least initially. This is due to differences in bid prices among potential buyers of the stock.

In a crude example, assuming a stock is trading at $100 and there are only 5 bids each for 100 shares as follows:

  • Buy 100@ $100.00
  • Buy 100@ $99.00
  • Buy 100@ $98.00
  • Buy 100@ $95.00
  • Buy 100@ $87.00

A trader who places an order to liquidate (sell) 400 shares of stock at market price will be met with the bid from each of the above offers to buy. Since the sell order will be executed at the highest bid, the first 100 shares will be sold at $100, the next 100 at $99, and so on, until the final 100 shares execute at $95. Thus the trader selling the stock is able to drive the price lower, simply by overwhelming the buyers with more shares than they are prepared to purchase in such a short period of time.

What happens next is something so important that it cannot be emphasized enough. The decrease in selling pressure due to the absence of that single seller, after that seller has liquidated the entire position, has a net effect of pushing the stock price higher.

In the above example, the stock price would likely have found a bottom, at least temporarily, once the large seller had liquidated the entire 500-share position. After that seller disappears, any buyers wishing to open a long position in the stock would need to buy from other sellers. It doesn’t take too many bargain hunters to quickly overwhelm sellers when an unusually large seller disappears.

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Copyrighted material – “fair use” as educational aid

Just as the market manipulator was able to drive the stock price lower by dumping more shares than buyers were able to handle, the disappearance of that seller often leads to the opposite – too many buy orders for sellers to handle. The result is that buy orders will tend to execute at the best price available, which means that buyers will have to pay higher and higher prices in order to get an order to execute. In the absence of a trader liquidating large numbers of shares, a string of buy orders can quickly climb the chain of ask prices.

The absence of shares available for liquidation by a market manipulator has the effect of reducing supply of those shares. As long as demand for the shares remains steady or increases, the stock price must increase when this supply of shares dries up. This can easily send stock prices to new highs, and sometimes to all-time highs. In this sense, all-time highs are a consequence of large players liquidating their positions.

The Other Shoe

Unfortunately, for those who do not realize that large market-manipulators have liquidated their stocks, all-time highs can be enticing. It’s difficult to step out of the market and sit on the sidelines while stock prices seem to climb higher day by day and week by week. Furthermore, a trader who tries to short stocks in such a market can quickly be ruined.

When large players leave the market, it is only a matter of time before the whole thing comes crashing down. Without their influence, and the stability they bring, the market cannot handle selling pressure.

When large players are absent, the smallest catalyst – a poor economic development, a surprisingly bad earnings report, perhaps a natural disaster – can lead to a major sell-off in stocks. Such a sell-off becomes magnified when sellers suddenly realize that they are in the market alone, without the normal presence of large players and institutions, thus their orders to sell take on a new urgency.

It is very easy for the stock market to make a switch from one full of confident small and individual retail traders making new highs, to one full of those same individuals running away scared.

A sell-off that occurs when individuals are getting out with as much of their life savings as they can salvage is much different than a sell-off that occurs when market manipulators are dumping shares. The manipulators’ actions do not last long, usually only a few weeks, or until their positions have been liquidated. The sell-off caused by the manipulators liquidation is limited; the sell-off following the liquidation is not.

When the other shoe drops, the market has historically shifted gears like night and day. There is no way of knowing with 100% certainty that the current stock market is one in which the other shoe is about to drop. But, the signs are there.

OMS 11-15-14b

While the performance of Covered Calls is a relatively new introduction for traders looking to identify large liquidations, other indicators may help confirm or refute such conclusions. For example, the ‘broadening formation’ chart pattern is a time-tested means of identifying price movements that tend to lead to major sell-offs. A broadening formation on the $SPY chart (daily or weekly chart) would thus lend credence to the signal generated by Covered Calls.

Decreasing trading volume would be expected to occur as stock prices reached new highs after a major liquidation event had subsided. Therefore, decreasing volume on a chart of the major indexes, such as the Dow, Nasdaq and S&P 500 would also support the hypothesis that the current highs were caused by a decrease in selling pressure, not an increase in buying pressure. Decreasing volume, along with a broadening formation on a chart of the major U.S. stock indexes would support the conclusion of the Covered Call analysis, being that the other shoe is getting ready to drop.

The following weekly 10-minute 3-step process provides further analysis.

Weekly 3-Step Options Analysis: 

On the chart of “Stocks and Options at a Glance”, option strategies are broken down into 3 basic categories: A, B and C. Following is a detailed 3-step analysis of the performance of each of those categories.

STEP 1: Are the Bulls in Control of the Market?

The performance of Covered Calls and Naked Puts (Category A+ trades) reveals whether the Bulls are in control. The Covered Call/Naked Put Index (#CCNPI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames.

Most important is the profitability of these trades opened 112 days prior to expiration, which balances sluggish responses of longer expirations with irrelevant noisy responses of shorter expirations.

 CCNPI 11-15-14

Covered Call trading did not experience a single loss in 2013, and the streak endured until October 11, 2014, ending a streak of nearly lossless trading extending all the way back to late 2011. That means the Bulls were in control continuously for nearly 3 years.

The Bears have now taken control and will likely remain in control for many weeks or months in spite of temporary rallies, no matter how bullish those rallies may appear. Historically, once the Bears have taken control, they do not relinquish that control until they have overstepped their authority over the stock market, as indicated by the Long Call/Married Put Index (#LCMPI) and Long Straddle/Strangle Index (#LSSI), shown below.

If the S&P falls below 1853 over the upcoming week, Covered Call trading (and Naked Put trading) will become un-profitable, indicating that the Bears retain control of the longer-term trend. Above S&P 1853 this week, Covered Calls and Naked Puts would be profitable, which is normally a sign that the Bulls are in control. However, such control is usually only temporary as long as the Bulls lack strength and confidence.

Profitability of Covered Calls and Naked Puts during a Bear market is not by itself evidence of a flaw in the analysis that determined a Bear market was underway. Profitability is only evidence of a flaw if it coincides with either Long Call profits or with excessive Long Straddle losses, as set forth in the descriptions of the Long Call/Married Put Index (#LCMPI) and Long Straddle/Strangle Index (#LSSI), shown below.

A level above 1853 this coming week would actually be quite within normal expectations for the early stages of a Bear market, specifically described as Bear Market Stage 6 in the chart above. The classic “dead cat” bounce creates temporary profits for Covered Calls and Naked Puts (#CCNPI) but not Long Calls or Married Puts (#LCMPI). A textbook “dead cat” bounce will also fail to exceed the level at which Long Straddle losses exceed 6% (#LSSI).

The reasoning goes as follows:

  • “If I can sell an at-the-money Covered Call or a Naked Put and make a profit, then prices have either been going up, or have not fallen significantly.” Either way, it’s a Bull market.
  • “If I can’t collect enough of a premium on a Covered Call or Naked Put to earn a profit, it means prices are falling too fast. If implied volatility increases, as measured by indicators such as the VIX, the premiums I collect will increase as well. If the higher premiums are insufficient to offset my losses, the Bulls have lost control.” It’s a Bear market.
  • “If stock prices have been falling long enough to have caused extremely high implied volatility, as measured by indicators such as the VIX, and I can collect enough of a premium on a Covered Call or Naked Put to earn a profit even when stock prices fall drastically, the Bears have lost control.” It’s probably very near the end of a Bear market.

STEP 2: How Strong are the Bulls?

The performance of Long Calls and Married Puts (Category B+ trades) reveals whether bullish traders’ confidence is strong or weak. The Long Call/Married Put Index (#LCMPI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames.

Most important is the profitability of these trades opened 112 days prior to expiration which balances sluggish responses of longer expirations with irrelevant noisy responses of shorter expirations.

 LCMPI 11-15-14

Losses on Long Call trading occurred in recent weeks for the first time in several months. Long Call trading became unprofitable this past March, Those losses intensified during April and early May before reverting back to profits for much of the summer. But the winning streak ended in mid-September. Losses for Long Calls are a sign of weakness for a Bull market. Such weakness can be dangerous because it lowers the perceived reward potential for stock owners, which makes stocks less attractive, in turn lowering the prices that stock-sellers are able to obtain from buyers.

As long as the S&P closes the upcoming week below 1997, Long Calls (and Married Puts) will remain un-profitable, suggesting the Bulls lack confidence and strength. Above 1997, Long Calls and Married Puts would become profitable for the first time in several weeks, which would suggest a significant shift in sentiment, notably a huge return of confidence by the Bulls.

Confidence and strength show up as a “buy the dip” mentality, while a lack of confidence and strength produces a “sell the rip” sentiment that tends to create brick-wall resistance, since each high is perceived as a rip to be sold. In a true Bear market, the Bulls will never be confident and strong; thus, Long Calls and Married Puts will never profit during a Bear market.

Profitability of Long Calls and Married Puts during a Bear market is therefore evidence of a serious flaw in the analysis which determined that a Bear market was underway, since it ostensively is not underway if these trades are profitable. Covered Calls and Naked Puts sometimes profit temporarily during Bear market bounces, but historically Long Calls and Married Puts have not.

The reasoning goes as follows:

  • “If I can pay the premium on an at-the-money Long Call or a Married Put and still manage to earn a profit, then prices have been going up – and going up quickly.” The Bulls are not just in control, they are also showing their strength.
  • “If I pay the premium on a Long Call or a Married Put and fail to earn a profit, then prices have either gone down, or have not risen significantly.” Either way, if the Bulls are in control they are not showing their strength.

STEP 3: Have the Bulls or Bears Overstepped their Authority?

The performance of Long Straddles and Strangles (Category C+ trades) reveals whether traders feel the market is normal, has come too far and needs to correct, or has not moved far enough and needs to break out of its current range. The Long Straddle/Strangle Index (#LSSI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames.

Most important is the profitability of these trades opened 112 days prior to expiration, which balances sluggish responses of longer expirations with irrelevant noisy responses of shorter expirations.

 LSSI 11-15-14

The LSSI currently stands at -2.5%, which is normal, and indicative of a market that is not in imminent need of a major breakout from the trading range of the last few months. Negative values for the LSSI represent losses for Long Straddle option trades. Small losses are quite normal and usual for Long Straddle trading. Large losses are not.

The 3 unusual conditions for a Long Straddle or Long Strangle trade are:

  • Any profit
  • Excessive profit (>4% per 4 months)
  • Excessive loss (>6% per 4 months)

Long Straddle trading (and Long Strangle trading) will not be profitable during the upcoming week unless the S&P closes above 2069 or below 1781. Values above S&P 2069 could only occur during a Bull market. Values below 1781 are certainly possible in a Bear-market environment, and should those values be reached it would suggest an oversold market poised for a bounce.

Excessive Long Straddle trading profits (more than 4%) will not occur unless the S&P either exceeds 2146 or else falls below 1704 this week. Values above 2146 can only occur in a roaring Bull market. Values below 1704 are certainly possible in a Bear-market environment, but would suggest that stock prices have fallen too far too fast for the rate to be sustainable, thus needing to correct higher, at least temporarily, in order to return to sustainability for the downtrend.

Excessive Long Straddle losses (more than 6%) will not occur unless the S&P moves to very near 1954 this week. Since excessive losses tend to coincide with a desire for traders to make stock prices break out, either higher or lower than the boundaries of their recent range, a level of the S&P near 1954 would likely bring a snap-back rally or else a violent resumption of the recent downtrend.

Breakouts in true Bear markets are always to the downside. Therefore, a continued move above 1954 in the coming week would indicate a serious flaw in the analysis that determined a Bear market was underway. Any level above 1954 is ‘clear and convincing’ evidence of such a flaw. That evidence becomes ‘beyond a reasonable doubt’ if accompanied by confirmation of Long Call profits, at or above S&P 1997 as shown by the #LCMPI above. A major move below 1997 this week would serve as confirmation that a Bear market was well underway.

The reasoning goes as follows:

  • “If I can pay the premium, not just on an at-the-money Call, but also on an at-the-money Put and still manage to earn a profit, then prices have not just been moving quickly, but at a rate that is surprisingly fast.” Profits warrant concern that a Bull market may be becoming over-bought or a Bear market may be becoming over-sold, but generally profits of less than 4% do not indicate an immediate threat of a correction.
  • “If I can pay both premiums and earn a profit of more than 4%, then the pace of the trend has been ridiculous and unsustainable.” No matter how much strength the Bulls or Bears have, they have pushed the market too far, too fast, and it needs to correct, at least temporarily.
  • “If I pay both premiums and suffer a loss of more than 6%, then the market has become remarkably trendless and range bound.” The stalemate between the Bulls and Bears has gone on far too long, and the market needs to break out of its current price range, either to a higher range or a lower one.

*Option position returns are extrapolated from historical data deemed reliable, but which cannot be guaranteed accurate. Not all strike prices and expiration dates may be available for trading, so actual returns may differ slightly from those calculated above.

The preceding is a post by Christopher Ebert, co-author of the popular option trading book “Show Me Your Options!” He 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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