Is this a correction or isn’t it? A very common response is that it is not a correction unless the market is down 10%.

10% - it’s a nice round number, easy to remember, and may appear to be a reasonable number from a technical standpoint; reasonable, that is, until we are reminded that this is the stock market we’re talking about.

The stock market is a land of a thousand technical indicators. So, isn’t it a bit suspicious that many folks are apparently relying on a nice round number – 10% - to tell them when the market is in a correction? Why not 12%? Why not 9.6%?

The truth is: the 10% figure, while easy to remember, is really not very useful for anything but news headlines. Just because the news media are shouting “correction”, based on their interpretation of a sell-off of more than 10%, does not necessarily mean it is a bad time to buy stocks; and just because the media are hesitant to declare a correction, because their 10% criterion has not been met, does not necessarily imply that buying stocks is a good idea.

It is important, for all traders, to avoid being distracted by talk of a correction, and instead be constantly aware of the condition of the stock market. To a trader who is aware, a correction is not a big deal, but simply one of several common types of market environments. There are rallies, consolidations, crashes, to name a few of the many stock market environments.  Focusing on only one environment - correction or the lack thereof - is probably not the healthiest thing a trader or investor can do.

The following analysis is presented here weekly, in order to make it easier for all traders to recognize all types of stock market environments, not just corrections. As of this past week, indications are that the market is not yet in a correction, but simply digesting the massive gains of 2013 and early 2014.

Click on chart to enlarge

*All strategies involve at-the-money options opened 4 months (112 days) prior to this week’s expiration using an ETF that closely tracks the performance of the S&P 500, such as the SPDR S&P 500 ETF Trust (NYSEARCA:SPY)

You Are Here – Bull Market Stage 2

Recognizing whether the stock market is currently at Stage 2 requires a quick analysis of the three categories (A, B, and C) of option strategies shown in the chart above, using a plus (+) for profitable strategies and a minus (-) for unprofitable ones.

• Covered Call trading is currently profitable (A+). This week’s profit was 2.9%.
• Long Call trading is currently profitable (B+). This week’s profit was 0.1%.
• Long Straddle trading is not currently profitable (C-). This week’s loss was 2.7%.

The combination, A+ B+ C-, occurs whenever the stock market environment is at Stage 2. Often times, Stage 2 is nothing more than a healthy digestion of the market’s recent gains. If so, then the S&P would be expected to soar back towards the highs of several weeks ago once it has spent enough time digesting the gains that resulted from those highs, typically several weeks.

For a complete description of all of the Options Market Stages, click here

What Happens Next?

What happens next depends on how muchfear the stock market has put into traders. Generally the greater the pullback in stock prices, the greater the fear. The greater the fear, the more likely traders will tend to be to sell their currently-losing stocks at break-even if they get the chance. Thus, the greater the amount of fear, the higher the chance will be that all those folks who bought stocks at their highs of early 2014 will be likely to sell them if prices return to those levels in the future.

It’s simple really, when considering ones own reaction to trading:

• You buy a stock at an all-time high because you believe the price will go up. Instead the price falls a little, but eventually rises back to your purchase price. You might have a little bit of fear, but your greed will likely force you to hold the stock for a profit. If a lot of other traders feel the same way, there will be little or no resistance when the price returns to its all-time high, and the price may indeed continue higher.
• After you buy the stock at its all-time high, the price falls quite a bit, but eventually returns to your purchase price. Here you may have mixed feelings about holding onto a stock for gains when it has already proven that it can cause you substantial losses. Your fear of repeating the loss may balance your greed of getting a gain on the trade. If a lot of other traders feel the same way, the stock price will probably encounter significant resistance when it rises to the previously-attained all-time high level, and will have difficulty, at least temporarily, rising any higher.
• After buying the stock at its all-time high, the price falls drastically. If you are like other traders who refuse to sell the stock at a loss, you will count your blessings the moment the price returns to its all-time high, giving you the opportunity to get out of the trade at break-even. Here, your fear of repeating the loss is likely to greatly outweigh your greed; and with many other traders feeling the same way, the stock price will act as if it has hit a brick wall if it eventually rises back to its all-time high price.

The broader stock market, as represented by the S&P 500, acts essentially the same as the above scenarios. To predict whether the S&P will encounter no resistance, significant resistance or brick-wall resistance, if it returns to its all-time high, requires a study of the amount of collective fear among traders. This study can be accomplished with the Options Market Stages.

For tips on how the above chart is created, as well as using it as a technical indicator, click here.

• At the current stage, Stage 2, the market has only pulled back slightly, despite media portrayals of an apocalypse. As long as the S&P falls no lower than the bottom of Stage 2 (above the yellow line on the chart), there is a good argument that the S&P could soar past its recent highs of 1840 – 1850 with little or no resistance.
• If the market enters Stage 3, the pullback will have become a little more severe. If the S&P declines into Stage 3 (below the yellow line on the chart), it is likely that any eventually rally back to the 1840 – 1850 level will hit a brick wall, at least temporarily.
• If the market enters Stage 4 (below the orange line), the pullback will have become so severe that there is no doubt it is in a correction. At this level, most traders are not concerned with resistance, as it is likely a long way off, but support. If it is just a Bull-market correction, then support will be found at or above the red line. If it is the beginning of something worse, a Bear market, then no support will hold and the S&P will sink below the red line.

 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.

Covered Call trading did not experience a single loss in 2013, and the streak endures so far in 2014, continuing a streak of nearly lossless trading extending all the way back to late 2011. That means the Bulls have been in control since late 2011 and remain in control today. As long as the S&P remains above 1708 over the upcoming week, Covered Call trading (and Naked Put trading) will remain profitable, indicating that the Bulls retain control of the longer-term trend. 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.

Long Call trading was profitable for almost all of 2013 except for a brief break from August through early October, and remains profitable today. However, Long Calls are now teetering on the dividing line between profits and losses. A return to losses would mark a significant shift in sentiment among traders, and would be a harbinger of weakening of the current Bull market. If the S&P closes the upcoming week below 1811, Long Calls (and Married Puts) will fail to profit, suggesting the Bulls have lost confidence and strength. 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.

The LSSI currently stands at -2.7%, which is within normal limits. Profits on Long Straddle trades will not occur this week unless the S&P exceeds 1863. That level is likely out of reach this week, although anything is possible. Anything higher than 1863 indicates the presence of euphoria, often accompanied by lottery-fever-type bullishness, so the S&P exceeding that level this upcoming week would indicate a remarkable recovery from the recent slump.

Excessive profits on Long Straddle trades, such as those exceeding 4%, will not occur this coming week unless the S&P rises above 1933. Despite the presence of euphoria, anything higher than 1933 is likely to result in some selling pressure, and historically has been associated with subsequent pullbacks and, occasionally, Bull-market corrections. Given the recent slump in the S&P, 1933 is likely way out of reach and therefore of no concern this upcoming week.

Excessive losses on Long Straddle trades, such as those exceeding 6% will not occur this coming week unless the S&P falls to 1757. At or near that level a subsequent breakout is likely.  Since 1757 is easily within reach if there is another sell-off this coming week, that level is important to watch, as anything below it is likely to indicate a major Bull-market correction is underway, and the market is likely to break out into a lower trading range.

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.