By Chris Ebert

There are times when it makes sense to follow an uptrend to its limit, and others when taking profits after rallies can be beneficial especially when there is an opportunity to buy back into positions on the dip. The ability to tell the difference can certainly come in handy.

There are relentless near-continuous rallies at times, and other times the rallies have pauses for consolidation and profit taking.

Of course, nobody can predict the future with certainty, and neither can any technical analysis system. However, an options analysis of the S&P has been accurate a fair percentage of the time at solving this dilemma for traders.

OMS 08-06-16

When the S&P 500 rises quickly enough so that expiring ATM $SPY 4-month Straddles* (opened 4-months earlier using a then at-the money strike price) are profitable, that is the green stage on the chart, known here as Lottery Fever. The name Lottery Fever comes from unrealistic euphoria that tends to infect traders, causing them to abandon the idea of basing their trades on economic data and corporate fundamentals, and instead focus their attention on buying stocks merely to get on the bandwagon with other traders as stock prices go up, up, up.

Currently, though, the S&P has not yet crossed the threshold into Lottery Fever. According to the Options Market Stages – an historically accurate manner of analyzing overall trader sentiment – this is a market that is still in a mode of Digesting Gains. That is to say, the market shows gains, and then profit takers come in and cash in some of those gains, usually followed by a resumption of the uptrend.

The result is that major indices such as the S&P 500, Dow and Nasdaq tend to have rather nice runs up, followed by some pullbacks. The pullbacks tend to be minor and short lived, and often don’t affect the overall uptrend in the long run. But a trader expecting nothing but up, up, up could be surprised when one of these pullbacks occurs. The temptation to sell stocks in order to protect profits could be overwhelming.

That’s not to imply that a pullback couldn’t be the start of a more serious downturn, and that selling stocks would be a mistake. Rather, it suggests that when the S&P 500 is inside the upper blue zone, that pullbacks are something to be expected, are usually temporary, and often better to ride out than to sell stocks at the temporary bottoms those pullbacks tend to form.

In the blue zone, Long Straddles* are not profitable. When those option trades are indeed profitable it often signals unrealistic euphoria. But when they are not profitable is tends to instead signal that the market still has realistic expectations and is paying attention to the news. Thus it can be expected that fundamentals still play a role in the blue zone, and that is why the S&P is often brought back to reality (reality from a fundamental perspective as well as a technical one) with a minor pullback now and again. Those pullbacks tend to coincide with negatively-perceived economic news.

The Digesting Gains stage for the S&P 500 is perhaps one of the most news-driven environments the stock market has to offer.

* 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)

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

 

 

Related Options Posts:

S&P 500 Awesome Chord Progression

Orange Line of Violence Often Influences Stocks

Thursday Evening Options Brief 18-Feb-2016

 

 

Leave a Reply

You must be logged in to post a comment.