By Chris Ebert
The best time to prepare for a Bear market, as with any foreseeable disaster, is long before it strikes. If one waits for word of a Bear market to be broadcast on the evening news, chances are good that it is already too late to prepare.
It’s too late to build a storm cellar when the tornado sirens are blaring, too late to get off the volcano when the pyroclastic flows have begun, and too late to buy bread and milk when the blizzard winds are howling. The best one can normally hope for, when a disaster is already underway, is to mitigate the damage; and that includes stock market crashes.
The problem with preparing for disaster is that there is a natural tendency to become desensitized to warnings that later prove inaccurate. As television’s Simpsons character Troy McClure observed many years ago, in 1995, “phony tornado alarms reduce readiness”. So to do phony predictions of coming stock market crashes reduce readiness.
Many have viewed the widely circulated charts showing the similarities of the current stock market to that of the Crash of 1929. While it is conceivable that such similarities could indeed mean we are headed for another stock market crash, the truth is that so many similar predictions have failed in the past that even if this one proves to be true it will likely be ignored, quite like phony tornado alarms.
As with any indicator, including stock market indicators, the value of the indicator depends on its ability to avoid as many false alarms as possible, while retaining the ability to send all valid alarms with enough advance notice to allow for time to prepare. Too many issued false alarms, too many missed valid alarms, or too many valid alarms issued too late, make any indicator useless.
With those constraints in mind, here is a nearly foolproof means of analyzing stock options in order to warn of a Bear market affecting the stocks in the S&P 500 while there is still time to prepare.
* 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. (e.g. Profit of $6 per share on an expiring Long Call would represent a 3% profit if $SPY was trading at $200, regardless of whether the call premium itself actually increased 50%, 100% or more)
You are here – Bull Market Stage 1 – the “Digesting Gains” Stage.
On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending September 6, 2014, this is how the trades performed on the S&P 500 index ($SPY):
- 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 profitable (B+).
This week’s profit was +2.0%.
- Long Straddle and Strangle trading is currently not profitable (C-).
This week’s loss was -0.5%.
Using the chart above, it can be seen that the combination, A+ B+ C-, occurs whenever the stock market environment is at Bull Market Stage 2, known here as the digesting gains stage. This stage gets its name from the tendency for stocks to experience periods of gains interspersed with significant pullbacks, as if traders are taking time to digest each individual gain. Digestion is often bullish, but not nearly as bullish as the recent lottery fever of Stage 1 which occurred in late August and early September.
A chart describing all of the different Options Market Stages is available by clicking the link at the left.
What is a Bear market?
In order to sound the alarm signaling the presence of a Bear market, the first step is to define exactly what a Bear market is. Such a task may seem simple enough, but it is not.
Take a typical definition of a Bear market being a 20% decline in stock prices. If every 20% decline in stock prices represented a Bear market, there would be no need to analyze the market further; a trader could become wealthy simply by buying stocks and holding them, only to dump them the moment a 20% decline came about.
The problem with rigid numerical definitions (e.g. a 20% decline) is that such rigidity does not allow for sufficient flexibility to avoid false alarms of a Bear market while simultaneously capturing every true Bear market with enough advance notice to allow for preparations (e.g. selling stocks).
Perhaps a better method of defining a Bear market is to simply state that it is a stock market in which the risk of owning stock is greater than the perceived reward.
The risk is tangible, and easily calculated; the reward is not. Stock prices can only fall to zero, at worst, so the risk of stock ownership is always known. The reward, on the other hand, is not known. Since stock prices have no upper limit, the potential reward of stock ownership cannot be defined, thus the potential reward is nothing more than the perception among traders of how high the stock price will go.
When stock prices are going up, the consensus among traders is generally that there is a reward. Traders may disagree on the amount of the potential reward, nevertheless they usually agree that there is a potential to profit from a continuation of the upward trend in prices.
If stock prices climb too far, too fast, the consensus can quickly shift. A perception that stock prices have reached a limit and have little potential upside can lead to a sell-off. Quite simply, the risk of loss (that stocks could go to zero) outweighs the perception of reward (that there is little chance of upside profits), stock prices can tumble until either the risk decreases, or the perceived reward increases, or both. When stock prices fall to a point at which an equilibrium is reached – when weighted risk equals the perceived reward – that’s when prices stop falling and begin to rise once more.
Sometimes, however, prices do not reach equilibrium, at least not for many weeks or months. In a cascading effect, falling stock prices sometimes do not represent bargains,
- In a Bull market – Falling prices cause an increase in the perception of the potential rewards of stock ownership, and a simultaneous decrease in risk.
Falling prices leave more perceived room for upside moves, thus the further stock prices fall the greater the perceived reward. As stock prices decrease in a Bull market, maximum risk decreases (since stock prices are getting closer to zero – zero being their lowest possible value) while perceived reward increases, thus equilibrium is reached relatively quickly as the two forces are moving towards each other.
- In a Bear Market – Falling stock prices cause a decrease the perception of the potential rewards of stock ownership, and a simultaneous decrease in risk.
Falling prices are perceived as likely to be followed by even more falling prices, thus the further stock prices fall, the lower the perceived reward. As stock prices decrease during a Bear market, maximum risk decreases (since stock prices are getting closer to zero – zero being their lowest possible value) but the perception of potential reward is decreasing as well. Equilibrium takes much longer to reach in a Bear market because the forces, risk and reward, are traveling in the same direction, not toward each other as in a Bull market.
In the most extreme example possible, if stock prices were to fall to zero in a Bear market there would be no risk in stock ownership but there would be a perception of a potential reward. Therefore, individual stock prices rarely go all the way to zero, even when a the company that issued the stock has gone bankrupt, as long as a glimmer of hope remains, no matter how faint.
Stock indexes, such as the Dow Jones, Nasdaq or S&P 500 are even less likely to go to zero than the individual stocks they contain, for the simple reason that the closer the index gets to zero, the lower the risk. Thus, the tiniest glimmer of hope for potential reward can outweigh the risk of going to zero, especially as the index gets closer to zero. Equilibrium, even in the most severe of Bear markets, will be reached long before a major stock market index reaches zero.
Importance of Option Traders in Bear Markets
The reward for an option trader is often quite different than the reward for a stock owner. Option traders can and do earn profits when stock prices fall. The fact that it’s possible for some option traders to profit from a Bear market, however, is an oft overlooked useful bit of information that can be used to identify a Bear market.
If chosen carefully, the profitability of certain options can serve as an early-warning Bear-market alarm for all traders, stock market traders included. Unlike the profitability of short-selling stocks, which occurs whenever stock prices fall regardless of whether the price decline constitutes a Bear market, certain specific options only profit during a Bear market.
Since every option contract has a buyer and a seller, the profit of every option owner is always equal to the loss of the seller and vice versa. The options market is truly a zero-sum game. Options neither create nor destroy wealth, but merely move wealth from one place to another. That’s a stark contrast to the stock market, in which wealth can be created as well as destroyed.
It is important to note the inability of options to have any net effect on total wealth, because any analysis of options that only includes positions that experience an increase in wealth must exclude all positions that experience a decrease. The profits and losses of individual option positions are meaningless unless the net positions are known. Individual options themselves are therefore often poor indicators of the stock market, however, combinations of options and stock positions often provide very meaningful data.
For example, a trader may buy 100 shares of stock and sell 1 standard Call option. The stock price may subsequently rise above the strike price of the option and the Call option owner may exercise the option. In this case the Call buyer may experience a profit, since exercising the Call option allows him to buy 100 shares of stock at the strike price of the option and then sell those 100 shares of stock at a higher price on the open market.
The Call seller may also experience a profit, as long as the purchase price of the stock was less than the net sales price, when accounting for the Call option premium received. Both the Covered Call seller and the buyer of that particular Call option can each make a profit at the same time, on the same stock.
In order to use options to determine whether a Bear market is underway, it is necessary to study only those options which would give stock owners a perceived reward that is greater than the risk of loss. This narrows down the list of potentially hundreds of possible combinations that would serve as a Bear market indicator, to just two:
- A stock owner can buy Put options (Protective Puts) to limit risk
- A stock owner can sell Call options (Covered Calls) to generate a reward
The presence of a Bear market, as outlined earlier, is evident whenever the risk of owning a stock is greater than the perceived reward potential. Also as previously outlined, not every decrease in stock prices results in a Bear market. Only those decreases in stock price that cause the risk of stock ownership to be greater than the perceived reward are bearish; declines that do not tip the risk/reward scale can often be healthy Bull market corrections.
A stock owner always has risk. The only way to eliminate risk completely is to sell the stock; and the only reason to eliminate risk completely is because of a perception that the potential reward is not worth the risk. As long as risk can be limited to a reasonable level by buying Put options, there is no immediate need to sell stocks that are owned.
Stock owners who buy Protective Puts can and do experience losses, but as long as Puts are cheap, the risk is relatively small. In a Bull market, when implied volatility is low, as is commonly indicated when the VIX is low (below 20), Puts are relatively inexpensive. It is unlikely if not impossible for a Bear market to begin while Put options are cheap – when the VIX is low.
No matter how deep a sell-off, no matter how severe a correction, as long as stock owners can limit risk with inexpensive Puts, the perceived reward of stock ownership will always be greater than the risk. A Bear market simply cannot take hold until the VIX is elevated, until Put premiums become so high that the risk of protecting stocks with Puts outweighs any potential perceived reward.
Even when option premiums rise, there is an alternative to stock owners. Rather than buy Puts for protection, they can sell Covered Calls against their existing stock positions. The higher the implied volatility (the higher the VIX) the higher the Call premiums; so the reward of stock ownership remains intact even during a decline in stock prices, thanks to the options market.
The only way the risk of stock ownership can become so great that it exceeds the perceived reward potential is for a stock owner to run out of suitable option alternatives. The stock owner can buy Protective Puts, and if that doesn’t offer enough reward for the risk, sell Covered Calls. If Covered Calls don’t offer enough reward for the risk, then there are very few suitable alternatives.
How much reward for the risk is acceptable? That’s certainly debatable. However, when there is zero reward for the risk, there is not really much left for debate. When a stock owner cannot limit risk to an acceptable level with at-the-money (ATM) Put options, or can’t create any reward at all selling at-the-money (ATM) Covered Call options, it’s time to sell the stock.
Sure, it’s possible the stock owner could use in-the-money (ITM) options and might be able to eke out a profit. But is it worth it? Buying ITM Protective Puts or selling ITM Covered Calls is a little like chasing a bus, and the profits, if there are any, are often not worth the effort, much less the risk of loss. That doesn’t mean all ITM options are bad choices; but when ITM options are the only ones a stock owner can use successfully, it might be better for a stock owner to just sell the stock and sit on the sidelines for a while.
Historical Success Identifying Bear Markets
The following chart shows the profitability of several common types of option strategies applied to the S&P 500 index as a whole. Above the yellow line, in the blue and green zones, stock owners who protect their positions by buying ATM Put options earn a profit. There’s no way a Bear market can begin if stock owners can buy Put options and still earn a profit; it’s simply not possible.
An expanded 10-year historical chart is now available.
Below the yellow line, in the yellow zone, stock owners may experience a loss if they protect their positions with Puts, however, stock owners who did not buy Puts can still earn a profit. Not every stock owner buys Puts for protection; some choose to trade without a safety net. Those traders will profit from rising stock prices, even when the increase is very small, since they are not spending anything on option premiums for protection. A Bear market is highly unlikely to begin when stock prices are still rising.
Below the orange line, in the orange zone, stock owners may experience losses, but not if they sold ATM Covered Calls against their existing stock positions. It is highly unlikely a Bear market could begin when stock prices fall, as long as it is possible for stock owners to continue to profit from their stocks, by selling Call options.
Below the red line, in the red zone, stock owners cannot experience a gain by buying ATM Put options or by selling ATM Covered Calls against their existing positions. Below the red line, the stock owner has run out of options… literally. The red line therefore defines the point, at any time, past or present, at which the risk of stock ownership outweighs the perceived reward.
A Bear market is almost a certainty below the red line, and almost certainly impossible above it. For historical perspective, the following chart shows the level of the S&P 500 relative to the red line. In other words, this chart shows how for the S&P would need to fall for a Bear market to begin (if a Bull market is underway) or how far the S&P would need to rise for a Bear market to end (if a Bear market is underway).
The chart below is formed by viewing the S&P 500 from the vantage point of the red line as depicted on the chart above. For the week ending September 20, 2014, the most recent date for which data was available, the red line in the chart above is located at the 1903 level for the S&P 500, so on the chart below the S&P is approximately 5.3% higher than the red line, at the 2010 level. 2010 (the current S&P level) = 1903 (the current red line level) + 5.3%.
For example, if the S&P 500 is 5% above a Bear market, a level of 2000 for the S&P would indicate that a decline of more than 5%, or 100 points, would likely cause a Bear market. A decline of 5% or less, 100 points or less, would be considered a Bull market correction. This gives traders an opportunity to place stop-loss orders in order to avoid losses caused by a Bear market.
The chart shows that Bear market alarms produced using the above methods are rare, yet the alarm never fails to sound when a Bear market is underway. No speculation, no comparison to disasters such as the Crash of ’29, just advance warning when it’s needed most.
A few areas of interest on the chart include:
- Identification of the beginning of the Mini-Bear market of 2011 on August 5, 2011 at S&P 1199 and its end on November 18, 2011 at S&P 1215 avoiding the intervening low of S&P 1122
- Identification of the beginning of the Mini-Bear market of 2010 on June 25, 2010 at S&P 1076 and its end on August 20, 2010 at S&P 1072 avoiding the intervening low of S&P 1010
- Identification of the beginning of the Crash of 2008 on July 11, 2008 at S&P 1239 and its end on January 23, 2009 at S&P 831 avoiding the intervening 400 point decline, albeit prematurely signaling the true end of that particular Crash by 30 days. Even so, only the final 150 points of losses for the S&P occurred during those 30 days, and a trader who bought stock could have avoided most or all losses associated with that final 150 point loss by selling ATM Covered Calls against each stock position. Covered Call sellers are always the first traders to become profitable when a Bear market ends.
- Very few Bear market false alarms were generated, most notably on June 1, 2012 and July 6, 2012, however a trader could easily have taken steps to avoid each of those nuisance signals, since each was triggered by the S&P being just 3 or 4 points inside the required range of a Bear market, too narrow a range to be meaningful considering the limits of error on the data are likely on the order of +/- 10 points.
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.
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 here, nearly 3 full years later, in 2014.
As long as the S&P remains above 1903 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. Below S&P 1903 this week, Covered Calls and Naked Puts will not be profitable, and since such trades only produce losses in a Bear market, it would suggest the Bears were in control.
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.
Long Call trading became unprofitable this past March, Those losses intensified during April and early May before reverting back to profits in recent weeks and months. 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 price stock sellers are able to obtain from buyers.
As long as the S&P closes the upcoming week above 1995, Long Calls (and Married Puts) will remain profitable, suggesting the Bulls retain confidence and strength. Below 1995, Long Calls and Married Puts will not be profitable, which would suggest a significant shift in sentiment, notably a loss 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 set recent highs as brick-wall resistance, since each test of that high is perceived as a rip to be sold.
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.
The LSSI currently stands at -0.5%, which is normal, and indicative of a market that is neither in imminent need of correction nor in 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.
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 2041. Values above S&P 2041 would suggest a continuation of the recent euphoric “lottery fever” type of mentality that tends to lead to a rally for stock prices.
Excessive Long Straddle trading profits (more than 4%) will not occur unless the S&P exceeds 2119 this week, which would suggest absurdity, or out-of-control “lottery fever” and widespread acceptance that stock prices have risen too far too fast for the rate to be sustainable, thus needing to correct in order to return to sustainability.
Excessive Long Straddle losses (more than 6%) will not occur unless the S&P falls to 1925 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 break higher from 1925 would be a major bullish “buy the dip” signal, while a break below 1905 would signal a full-fledged Bull market correction was 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.