By Chris Ebert

Sometimes the S&P falls below the 50-day simple moving average (50sma) only to recover quickly, as it did this past week. When it does recover, there are occasions when that very recovery gives traders the confidence to push stock prices to new highs. Other times, the recovery seems to fizzle out within a few days.50day sma

Why the difference? It may have to do with the Options Market Stages. If the recovery pushes the Options Stages to Stage 5, it tends to spawn a new bullish cycle, which can lead to new highs. If the recovery merely brings the Options Stages back to Stage 3, it may mean the continuation of a stagnant period of range-bound trading that can spawn the next sell-off to a major support level.

Welcome to Options Bull Market Stage 5 (maybe)

When the S&P is in Stage 3 (the yellow zone in the following chart) as it has been for the past several weeks, it generally experiences strong resistance when it tests the highs. This resistance tends to develop into a brick wall through which the S&P cannot go. Stage 4 – the “correction stage” – erases the brick wall

The S&P 500 dipped quite a bit early this week – so far, in fact, that it was deep in what can be considered “correction” territory (the orange zone in the chart). A Bull-market correction can often be considered a great opportunity for traders, because as long as a Bear market does not ensue, the correction usually spawns an impressive rally in stocks; and the rally often breaks right through the previous brick wall. That can send stock prices to new record highs.

The only fly in the ointment for the Options Market Stages this week is that the dip into “correction” territory was so brief (only lasting one day) that it does not even show up on the weekly chart of the Options Market Stages. Thus there are questions as to whether it really represents a true correction. If it does, the previous brick wall has likely crumbled and the market has entered Bull Market Stage 5. If not, the brick wall could be stronger than ever as Stage 3 is continuing uninterrupted. Note: Bull Market Stage 5 exists in the yellow zone, but is not labeled here (for chart clarity), since it also occupies the same space as Bull Market Stage 3. Bear Market Stage 5 is the red zone.

A longer-term 10 Year History of the Options Market Stages is available.

OMS 06-11-15

* 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 tend to progress in a natural order known as the Ebert Cycle as shown in the chart at right.

Options Market Stages

Click on chart to enlarge

The general progression in a healthy Bull market is from Stage 0 to Stages 1,2,3,4,5. Once Stage 5 is reached, the process quickly begins again at Stage 0. However, when a Bull market is very mature, such as the current Bull market which has lasted some six years now, the Ebert Cycle starts to break down. The progression becomes progressively less predictable until it eventually stops completely and a new Bear market takes hold.

Or is this Stage 3?

As can be seen on the chart, Bull Market Stage 3 (where the market has been for several weeks) is not very distinguishable from Bull Market Stage 5. In each of those stages Covered Calls and Naked Puts are the only options strategies to return a profit. The only difference is that Stage 3 occurs before a correction and Stage 5 occurs after a correction.

The level at which stock prices bounce is very important. Too low, and the bounce can be considered a temporary dead-cat bounce; too high and the level of support can be meaningless. A bounce that occurs after a complete Bull-market correction (no more, no less) is the sweet spot that leads to the sounding of the all-clear signal. When the S&P corrects right to the border separating a Bull and Bear market (the red line on the chart above), the all-clear tends to be very dependable.

The implications for this week’s analysis are that it is difficult to have any confidence in the current Options Stage. The market may be in Stage 3 (brick wall resistance) or it may be in Stage 5 (the “all clear” signal for stock owners). The only way to know which is correct is to see what the market does next.

If stocks suddenly break out to new record highs (above S&P 2130 for example) without immediately retracing back down, then it is likely Stage 5 is well underway. If stocks fail to make new highs in the next couple of weeks or so, then it is quite likely the market never left Stage 3.

Unfortunately, the options market does not always show a clear answer; and this is one of those times. However, with close attention to stocks during the remainder of the month of June, the answer should become clear to anyone who follows the Options Market Stages.

Whether traders are watching the Options Market Stages, or whether simply watching for a breakout to new highs, it is always important to watch for the placement of a Bull Trap. Such a trap can be set to mimic a breakout to new highs, thus luring bullish traders to buy stocks, when in reality it is a false short-lived breakout preceding a major sell-off. Unfortunately a true breakout may not be distinguishable from a Bull Trap, except in hindsight.

For additional insight into the Options Market Stages, see the following 10-minute, 3-step analysis presented here each week.

Weekly 10-Minute 3-Step Options Analysis: 

STEP 1: #CCNPI – Bull or Bear Market?

How the #CCNPI works: Option traders know that Covered Calls (and Naked Puts) generally only return losses during a Bear market. Therefore, if Covered Calls are profitable, it’s a Bull market, if not it’s a Bear market.

The Covered Call/Naked Put Index (#CCNPI) measures the performance of Covered Call trades at expiration, specifically on the S&P 500 (using $SPY or $SPX options) when opened at-the-money 4-months to expirationIf the #CCNPI is positive, it’s generally indicative of a Bull market for the S&P 500; negative values indicate a Bear market is likely underway.

 CCNPI 06-11-15

The reasoning for the #CCNPI 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: #LCMPI – Strength or Weakness?

How the #LCMPI works: Option traders know that Long Calls (and Married Puts) generally only return profits during periods of strength. Therefore if Long Calls are profitable, bullish traders’ confidence is probably strong; if not then their confidence is probably weak.

The Long Call/Married Put Index (#LCMPI) measures the performance of 4-month ATM $SPY options. If the #LCMPI is positive, it’s generally indicative of strong bullish confidence in the S&P 500; negative values indicate weak confidence.

LCMPI 06-11-15

The reasoning for the #LCMPI 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: #LSSI – Are Traders Feeling Surprised or Normal?

How the #LSSI works: Option traders know that Long Straddles and Long Straddles only return profits after surprisingly large moves in stock prices, only return losses when stock prices move surprisingly little, and tend to break even under normal conditions. The performance of Long Straddles and Strangles therefore reveals whether traders feel the market has come too far and needs to correct, or has not moved far enough and needs to break out of its current range, or has moved as expected and is acting normal.

The Long Straddle/Strangle Index (#LSSI) measures the performance of Long Straddle trades on the S&P 500 index when opened at-the-money 4-months to expiration. When the #LSSI is excessively positive (more than +4%) it is indicative of stock prices having moved surprisingly far, surprisingly fast, thus needing to correct a bit. When the #LSSI is excessively negative (less than -6%) it indicates that stock prices have moved surprisingly slow, thus traders may feel the need to push prices out of the range to test them (a price breakout). When the #LSSI is between +4% and -6% it is indicative of stock prices moving at the expected pace, thus producing neither an overwhelming need to correct nor to breakout.

 LSSI 06-11-15

The #LSSI is based on the premise that Long Straddle trades are only profitable in a surprisingly overextended market, particularly at-the-money long Straddles representing a wide cross section of the stock market, and with reasonably distant expirations.

The reasoning for the #LSSI 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 (both options together forming a trade known as a Straddle) 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.

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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