By Chris Ebert
Traders occasionally become disenfranchised. They feel like they have become disconnected from the market – that the trading environment has changed so drastically that they cannot make a confident interpretation. That tends to happen when the S&P 500 Temperature reaches extremes.
Any Temperature above +200 or below -200 is considered extreme. Extreme low Temperatures are associated with intense Bear markets, and it is obvious that traders would feel disenfranchised then. But traders can become just as disenfranchised when the Temperature in a runaway Ball market rises to the extreme levels seen recently.
Currently the Temperature is well above 200. That means the stock market is very hot; and it explains why folks who own stocks are reluctant to sell. That explains why stock prices have not had any major pullbacks in recent weeks. It also explains why those on the sidelines are reluctant to buy stocks, in turn leading to no significant increase in trading volume. Nobody’s selling, nobody’s buying.
When the Temperature rises this high, those who own stocks are often unwilling to part with them, hoping that the rally in prices will continue. But those disenfranchised traders sitting on the sidelines are less willing to buy stocks at such lofty levels for fear they could be buying immediately prior to a pullback. The result is often a decrease in trading volume. Fewer traders are selling their stocks on which they recently saw huge gains, but fewer traders are buying because they fear prices have reached a top.
There are implications. Since fewer buyers are willing to enter the market now, should a catalyst in the form of poor economic news entice sellers to part with their stocks, there will be fewer traders willing to buy them. While there is no way to predict whether such a catalyst will come along, if it does it would likely result in a quick and severe pullback in stock prices. Sellers would be scrambling to take the gains they have seen over the past several months, while buyers would be difficult to find until the Temperature reached a more reasonable level. The end result would be that sellers would have to settle at lower stock prices.
The effect can be seen on a chart of the S&P 500 index, in which trading volume has been quite low lately, but rose significantly during a rather meager pullback this past week. One can imagine what would happen if there was a major news event to act as a catalyst at this Temperature.
It is only natural to feel disenfranchised when the S&P Temperature gets as high as it is right now; and maybe that’s a good thing. A feeling of disenfranchisement can keep a trader from venturing into a market environment that they are not comfortable trading; and while it may cause them to miss out on gains, it could also save them from big losses.
The preceding is a post by Christopher Ebert, 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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