By Chris Ebert

Welcome to Bear Market Stage 6. It’s been a while since the last time the S&P 500 entered a Stage 6 environment. The most recent time was June of 2011. Many new traders may never have encountered this type of trading environment, and many seasoned traders may have become a bit rusty when dealing with one. So, it makes sense now to re-examine what makes Stage 6 tick.

In a textbook manifestation of Stage 6, the S&P 500 will encounter the infamous dead-cat bounce – an often impressive, yet temporary rally in what later turns out to be an overall downtrend that lasts for several months to a year or more.

Despite the coarse language, a dead-cat bounce is an apt description of how stock prices can bounce higher even when the overall uptrend is dead and gone, in much the same way a dead cat might bounce if dropped from a height. When Stage 6 is underway, there is a high probability that stock prices will broadly exhibit a dead cat bounce.

There is never a guarantee that a dead-cat bounce will occur. There are no guarantees in the stock market. There are only probabilities based on historical occurrences. Historically, Stage 6 favors a temporary rise in stock prices, followed by a resumption of the downtrend.

OMS 10-18-15

On the chart, it can be seen that Stage 6 encompasses the orange zone. What that means is that anytime the S&P 500 is in the orange zone it should act as if it “wants” to put in a dead cat bounce.

There are two important things to note about the orange zone:

First Thing to Remember about the Orange Zone

The orange zone is also known as Bull Market Stage 4. As can be seen, earlier in 2015 the S&P was in Bull Market Stage 4 – the “correction” stage. At that time, the orange zone represented the most likely area for the S&P to experience a Bull-market correction (a pullback of 10% or so off the highs). However, Bull-market corrections only occur during Bull markets.

Now that it seems likely a new Bear market is underway currently, a Bull-market correction can no longer occur. Bull-market corrections, by definition, cannot occur during Bear markets. Of course, everyone has their own personal definition of a Bear market. For simplicity, here a Bear market is defined as a dip below the red line that lasts at least several weeks. By that specific definition, a Bear market for the S&P 500 began on August 21, 2015 and is currently still underway.

  • When a Bull market is underway, the orange zone represents “correction” – a temporary decline in stock prices during an overall uptrend.
  • When a Bear market is underway, the orange zone represents “Phew!” a collective sigh of relief for stock owners because it is a temporary increase in stock prices during an overall downtrend. Thus, the orange zone previously represented Stage 4, but currently represents Stage 6.

The distinction between Stage 4 and Stage 6 is important because the trading environments are as different as night and day. Stage 4 serves up buy-the-dip opportunities – chances for traders to add to stock positions while prices are temporarily low. Stage 6, by contrast, serves up opportunities for traders to sell-the-rip – to get out of stock positions at relatively high prices before the bottom falls out again.

The chart below shows the typical “textbook” progression of a Bear market downtrend. As can be seen, as long as the S&P 500 follows the textbook version of events, Stage 6 is nothing more than a last gasp, a time to get out of stocks.

Progression of Bear Market Options Stages 2015

What confounds most every trader during Stage 6 is that it often gives the appearance of a resumption of the previous bullish uptrend. Nobody likes missing out on a rally; and there is no way of knowing for certain that the rally won’t turn out in hindsight to have been the beginning of the next leg up in a roaring bullish uptrend. That is what makes Stage 6 so very dangerous. There is no way of knowing for certain that the S&P 500 will follow the textbook.

Stage 6 gives the appearance that the uptrend is resuming, but quite often it does not resume in earnest until a much deeper decline in stock prices has occurred. However, Stage 6 cannot predict the future. Anything can happen in the stock market. It is certainly possible for a Bull market to resume despite the existence of Stage 6.

Second Thing to Remember about the Orange Zone

Some might wonder what good Stage 6 is an indicator if it cannot predict the future. The answer is simple. Stage 6, as with all the Options Market Stages, is an indicator of the current trading environment. Stage 6 is almost always accompanied by a sell-the-rip mentality. As long as the S&P 500 remains in the orange zone, that mentality is likely to remain intact. But, if the S&P goes outside the orange zone, the overall sentiment can change very quickly.

black tuesdayFor example, if the S&P 500 enters the black zone “Bull Market Stage 0”, the widespread sentiment among traders is likely to shift to a decidedly bullish one. There is no way of predicting whether the S&P 500 will indeed move into the black zone. All a trader needs to know is that sentiment will change drastically if the S&P 500 does enter the black. A trader who is prepared to take advantage of such a shift to bullish sentiment will be better prepared than others who are not able to perceive the shift in sentiment.

Conversely, if the S&P 500 fails to enter the black zone, an overall sell-the-rip sentiment is likely to remain. A trader who remains extra-cautious in the face of rallies that occur while the S&P 500 remains in the orange zone will be better prepared for steep sell-offs that might occur as a result of the lingering sell-the-rip mentality.

As long as Stage 6 is underway, a trader should never ask “what could have possibly caused today’s massive sell-off?” because the answer is self-evident. The mere fact that Stage 6 is underway is an indication of a collective desire of traders to take profits quickly during rallies and to sell stocks quickly during declines. There is simply a lack of confidence during Stage 6. Many folks “want” the rally to resume. People like to be bullish. But they just don’t have evidence to support those desires during Stage 6.

To sum it all up:

  • Stage 6 is now underway and will remain underway as long as the S&P 500 remains in the orange zone.
  • Should the S&P climb back into the black zone, Bull Market Stage 0, then sentiment would likely shift drastically and the previous 6-year uptrend in stock prices would have a high probability of resuming.
  • Should the S&P fail to get back into the black zone, the recent bearish downtrend would have a high probability of resuming, likely resulting in the beginning of Bear Market Stage 7 – the “look out below” stage.

It is interesting to note that it doesn’t take a huge rally in stock prices for the S&P 500 to get back into the black zone. Sentiment changes with the passage of time, just as it changes with rising or falling stock prices.firecracker

Should the S&P drift sideways for several weeks, it could also enter the black zone. The reasoning is straightforward. Traders who fear a massive sell-off tend to become less fearful every day that such a sell-off fails to materialize. Similar to lighting a fuse on a firecracker that then fails to explode, there tends to come a point at which folks realize it’s likely never going to explode – it’s a dud.

On the chart above, it can be seen that if the S&P would need to top 2150 or so to get into the black zone here in October. But, at just 2050 or so this December, it could potentially be in the black zone. Essentially, a massive rally now would boost confidence and cause a shift to a decidedly bullish sentiment; while a sideways drift without a massive bloodbath for several weeks would boost confidence by way of providing a sense of strong support. Either way, the black zone marks the shift in sentiment. Predicting whether that shift will occur – that’s beyond the scope of the Options Market Stages.

For easy reference, the textbook progression of the Options Market Stages is shown in the following chart.

Options Market Stages

Click on chart to enlarge

* 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). Profit and loss is calculated as the dollar profit of each option position as a percentage of the underlying share price.

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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