With the U.S. markets currently in a long holiday weekend, many traders are likely enjoying a break from market analysis. So here is something to consider that will only take a few moments, but may prove to be an immense help during the week ahead.
A type of option trading, known as Long Call* trading, is usually profitable whenever a strong Bull market is underway. Conversely, whenever a strong Bull market is underway, Long Call trading is profitable.
Although the S&P soared 2.5% higher this past week, a holiday-shortened week no less, Long Call trading remained unprofitable. Thus, this is not a strong Bull market, at least not from the perspective of a Long Call trader.
A weak Bull market can strengthen – that is always a possibility – so it would not be beyond comprehension if stocks continued to rally during the coming week. But, at the same time, traders should be prepared in case the already weak Bull market weakens further.
“Buying stocks when Long Calls fail to profit is tantamount to fighting the tides of the sea.”
*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)
When Bull markets become weak, pullbacks can be both swift and severe, and they can occur with or without accompanying economic news. If a significant sell-off does indeed occur in the next few weeks, readers here may want to consider that the reason for such a sell-off may be nothing more than weakness, as evident in the S&P’s failure to climb any higher than Bull Market Stage 3 this past week.
You are here – Bull Market Stage 3.
On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending April 12, 2014, this is how the trades performed:
- Covered Call trading is currently profitable (A+). This week’s profit was +2.7%.
- Long Call trading is currently not profitable (B-). This week’s loss was -1.5%.
- Long Straddle trading is not currently profitable (C-). This week’s loss was -4.2%.
Using the chart above, we can see that the combination, A+ B- C-, occurs whenever the stock market environment is currently at Bull Market Stage 3. For a description of Stage 3, as well as a comparison to all of the other stages, the following chart is provided:
What’s next?
As can be seen on the chart above, the stock market tends to progress through a Bull market in a “textbook†manner – beginning at Stage 0,  then 1, 2, 3 and 4, before bouncing higher at Stage 5 and then repeating the process all over again beginning at Stage 0.
The market, however, occasionally is not as well behaved as a textbook example. Occasionally Stage 4 is followed by a reversion to Stage 3 instead.
While Bull Market Stage 5 is often an “all clear†signal that the S&P 500 has bottomed out and has completed a “correctionâ€, a reversion to Stage 3 offers far less confidence that such a bottom has occurred. While by no means mandatory, a market that reverts to Stage 3 prior to reaching a major support level may be setting itself up for a test of support in the near future.
