By Chris Ebert

When traders study the stock market, there are many methods for determining price levels that are likely to act as support – levels to which stock prices fall but don’t fall any further. In fact, one of the first things that many folks learn when they begin trading is that there are levels that act in an almost magical way to provide support.

Only when something drastic changes the outlook for a stock does the stock price fall below support. The rest of the time, it is quite common for a stock price to bounce higher each time it falls low enough to touch support. Essentially, the market provides support for the stock whenever it touches a certain level as long as the economic outlook has not deteriorated.

resistance and supportThe manner in which support levels function is not rocket science. Since stock prices fluctuate up and down day to day, it is only logical that there will be times that the price will appear to be expensive and other time when it will seem like a bargain.

When traders perceive a bargain they are inclined to enter an order to buy. The better the bargain, the more traders are likely to step in with buy orders. If the influx of buy-orders creates more demand than the supply of shares currently offered for sale, the stock prices rises. Thus, under normal conditions a stock price will rise each time it appears to be a bargain – each time it touches support.

Since every trader perceives the market differently, there is no single level that all traders will agree represents a support level. Nevertheless, in any large group there are likely to be areas of consensus; and the stock market is no different. There are levels for stock prices that tend to generate a consensus of perception among a sufficient number of traders that those levels tend to act as support.

Some levels logically present themselves as a basis for support. Perhaps the most ubiquitous is the 200-day simple moving average. When a stock price falls to its average price over the past 200 trading days, it logically tends to trigger a perception of being a bargain for a large number of traders. The problem with ubiquity is that it can influence perception.

If large swarms of traders rely on the 200-day moving average as a signal of support, then that level can actually act as support even in the absence of a perception that it represents a bargain. In other words, traders may buy at the 200-day because of peer pressure – because it is a common practice – not because they necessarily sense a bargain.

On the other hand, there are support levels that are not ubiquitous; and these levels are less likely to be unduly influenced than more commonly-used ones. When a stock price bounces at a level that few traders are watching, then it is safe to say that there was a widespread perception that the stock became a bargain at that price. When a stock price bounces at the 200-day average, there is no way to know whether it simply bounced because lots of traders left a standing order with their brokers to buy at the 200-day.

Certainly, fewer traders are aware of derivatives such as stock options than of stocks. So it is likely that any support level generated by an analysis of stock options would be unlikely to be as widely used as a support level generated by stock prices themselves. As such, if stock prices bounce higher when touching a support level generated by an options analysis it is likely that the bounce occurred because of perception, not because of ubiquity.

SNP Temperature -4

That was the case this past week when the S&P 500 bounced higher after reaching an S&P 500 Temperature of zero. The S&P 500 Temperature is generated by an options analysis. While there are folks who watch the Temperature, it is certainly nowhere near as widely used as a stock price level, as the 200-day simple moving average, for example.

Thus, the fact that the S&P bounced almost exactly at a Temperature of zero is evidence that the Temperature correlates quite well with perception at the moment. This past week, a Temperature of zero would have been represented by a level of the S&P 500 of 2048. That’s the exact level that would have been necessary for certain of the week’s specifically defined Covered Call* trades to break even. (*see description below)

Since Covered Call trading tends to be profitable only in a Bull market and unprofitable only in a Bear market, the break-even point divides Bull from Bear. An S&P 500 Temperature of zero represents the dividing line between a Bull and Bear market. In some ways it’s the ultimate support level. If stocks find support when the S&P Temperature touches zero, it’s a pretty good bet the Bulls are still in complete control.

As it turned out, the S&P fell as low as 2044 last week. That level was represented by an S&P 500 Temperature of -4. That means the S&P fell just four points below the dividing line between a Bull and Bear market before it found support – four measly points. At today’s levels, four points is essentially nothing, and the fact that the S&P bounced so close to zero is evidence that a Temperature of zero currently represents a widespread perception of a bargain.

As long as an S&P 500 Temperature of zero continues to provide support for the S&P in coming weeks, then it can be inferred that nothing in the trading environment has changed significantly. This is still a Bull market; and traders buy stocks when they see a bargain, but they don’t panic.

However, if the Temperature suddenly falls below zero in coming weeks, that would be an indication that perception has changed – that the trading environment itself has changed. A Temperature of zero is shown by the red line in the chart below.

OMS 07-11-15

Traders therefore should be on the lookout for any dip in the S&P 500 below the red line regardless of whether it fails to violate more ubiquitous levels of support such as the 200-day moving average. A dip into the red zone is likely to be accompanied by an increase in panic levels, and those panic levels could potentially be present even if the S&P remains above more traditionally-recognized support levels.

* 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

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