By Chris Ebert
Note to readers: Only the charts and the Market Summary change from week to week. All other text remains the same, in order to allow regular readers to quickly absorb the entire Brief.
Each Thursday evening, we take some time to reconcile some of the varied options indicators available for the S&P 500. These indicators are unique to zentrader, and were developed in order to give readers an edge in the stock market.
These indicators were meant to be tangible – easily understood at a glance – thus providing an instant snapshot of the stock market to anyone regardless of trading experience, or the lack of experience.
Taking the Stock Market’s Temperature
First, we take the stock market’s Temperature. We need to know if the stock market is hot right now, or if it has cooled off. In other words, is this a hot Bull market in which stock prices are going up, or a cold Bear market in which stock prices are tumbling?
To take the Temperature of the S&P 500, we look at the performance of a simple option trade known as a Covered Call. Covered Call trading is almost always profitable in a Bull market, and very often results in losses in a Bear market. Conversely, if Covered Calls* are profitable it is currently a Bull market, and if Covered Calls are returning losses it is a Bear market.
We consider the point at which Covered Call trading breaks even – returns zero profit and zero loss – to be an S&P 500 Temperature of zero. Then we determine whether the S&P 500 is above or below that all-important break-even point. By measuring the distance of the current level of the S&P 500 from the break-even point we determine the Temperature. Above zero indicates a Bull market; below zero indicates a Bear market is in progress.
The historical 10-year chart of the S&P 500 Temperature (above) shows its importance as an indicator. Not only are Bear markets highly-correlated with sub-zero Temperatures, the sub-zero readings often occur before stock prices have broadly declined 20%. Furthermore, the Temperature rarely falls below zero during a Bull market, so no matter how severe a pullback occurs in a Bull market, the uptrend almost always continues as long as the Temperature doesn’t dip much below the zero mark.
Temperature Determines Trading Climate
Next, we use the S&P 500 Temperature to determine the type of trading environment that is most likely to be prevalent in the stock market. Perhaps not surprisingly, hotter temperatures tend to coincide with a more positive outlook, thus more exuberance for those buying stocks. Lower Temperatures tend to correlate with fear and a propensity to sell stocks.
It should be noted that the Temperature ranges above represent a continuum. That is to say, they are not written in stone. For example, a Temperature of 1 degree below zero does not somehow magically represent a shift to a Bear market. Nevertheless, the ranges have been historically accurate in a wide variety of market environments for well over a decade.
All stock-market indicators are prone to fail at times, and the Temperature is no different. Though rare, below zero readings have occurred outside of Bear markets. Most recently, the S&P 500 Temperature dipped below zero in October 2014 without an accompanying Bear market ensuing, one of only a few such occurrences in past decades.
Once we have associated the current Temperature with the current Stage of the market, it is possible to plot that Stage on a graph.
Trading Climate fits Elliott Wave Analysis
Traders often use an Elliott Wave analysis to help determine the reason for current trends in the stock market. Because traders act as a herd, and because herds tend to react in a somewhat predictable pattern, stock prices tend to follow a pattern as well. That pattern can sometimes be reasonably outlined using the Elliott Wave theory.
Here we use the current S&P 500 Temperature to determine the current Stage of the stock market. Then we mark the most appropriate spot on a typical Elliott Wave which correlates to previously-calculated Stage.
Since most S&P 500 Temperatures can only be achieved during one specific Options Market Stage, choosing the current location on the Elliott Wave is simply a matter of matching the current Stage to the Wave. Some Temperatures, though, can occur in a number of different Options Market Stages, and require some additional insight.
For example, Bull Market Stage 2 and Bull Market Stage 0 each occur at a Temperature between +125 and +200. As can be seen on the Elliott Wave above, Bull Market Stage 0 only occurs after a major decline in stock prices has bottomed out, while Bull Market Stage 2 occurs when stock prices are consistently rising. Thus, we can usually differentiate Stage 0 from Stage 2 by knowing how the market has been behaving in recent weeks.
Similarly, a Temperature of 0 to +75 is associated with four different Options Market Stages:
- Bull Market Stage 3 occurs only when stock prices have recently risen but have hit a brick wall of resistance and are having trouble rising further.
- Bull Market Stage 5 occurs only after stock prices have tested a major support (such as the 200-day simple moving average) without sinking into a Bear market.
- Bear Market Stage 6 occurs only after stock prices have fallen well below a major support (200-day simple moving average) and then recovered quickly in a matter of days or weeks.
- Bear Market Stage 9 occurs only after a protracted period of declining stock prices lasting many weeks or months.
Taking into account those extra bits of information, it then becomes possible to determine the current Options Market Stage rather accurately. Plotting it on the Elliott Wave chart then becomes just as accurate. We can then use the Options Market Stage calculated above to determine the current trading environment in the stock market.
Since the market is now rather bearish, using the Elliott Wave as a guide, we may find it helpful to plot the expected movement of the S&P 500 based on past Bear markets.
Verifying the Analysis
As can be seen on the Elliott Wave graph, the “You Are Here” sign points to a specific combination of profit and loss on some simple option strategies.
- Covered Calls and Naked Puts
- Long Calls and Married Puts
- Long Straddles and Strangles
If the S&P 500 Temperature has allowed us to choose our current location on the Elliott Wave graph correctly, we should be able to verify it by looking at the performance of those three strategies.
The following chart shows the current performance of each of those three strategies using at-the-money options opened 4-months ago on $SPY (NYSEARCA:SPY) which expire this week.
A 10 Year History of the above chart is now available.
Breaking it Down
To further illustrate the current stock market trading environment, we can break down the chart of the Options Market Stages to show the individual performance of each of the three options strategies.
- The performance of Covered Calls and Naked Puts shows us whether the current stock market is most likely to predominantly have either a bullish or a bearish sentiment.
- The performance of Long Calls and Married Puts tells us exactly how strong or weak any bullish sentiment is likely to be.
- The performance of Long Straddles and Long Strangles indicates whether the current trend is surprisingly over-extended (and therefore needs to reverse) or whether the current market has become excessively range-bound (and needs to break out of the range) or whether it is normal (neither in urgent need of a reversal nor in need of a breakout).
#CCNPI – The S&P 500 Covered Call/Naked Put Index
#LCMPI – The S&P 500 Long Call/Married Put Index
#LSSI – The S&P 500 Long Straddle/Strangle Index
Once again the S&P 500 appears to have entered Bear Market Stage 7. While it appears as though the stock market has made the transition from Stage 6 to Stage 7 it is not written in stone. It really takes a week of two in which the S&P remains inside the confines of Bear Market Stage 7 to verify that the market has indeed made the transition.
The chart of the Options Market Stages shows Stage 7 as the red zone. Thus, if the S&P remains in the red zone over the next week or so, it would be a reliable indicator that the shift to Stage 7 has been accomplished.
The violet zone is also technically indicative if Stage 7, though it often takes a while for Stage 7 to mature before the S&P will enter the violet zone. Regardless, the area comprised of the red zone and the violet zone will be very important to watch for the next week or so.
The S&P 500 Temperature almost always remains below zero once Bear Market Stage 7 has begun. Thus, traders who watch the Temperature updates on Twitter should look for consistent sub-zero Temperatures as confirmation. If the Temperature pops back above zero, it could indicate that Stage 6 is not yet complete.
Stage 7 is often the most prolific when it comes to sell-offs, especially sell-offs that seem to come as a surprise. Stocks can dip much further than expected; and the element of surprise tends to exacerbate the selling pressure.
Later, in Stage 8, when the stock market outlook has become bleak, sell-offs are not so much as a surprise as they are a foregone conclusion. But when Stage 7 is underway the prospect of a Bear market still tends to surprise many traders.
Very often stock prices have not yet declined 20% off their highs (the traditional measure of a Bear Market) when Stage 7 begins. That leaves many traders with a glimmer of hope that sell-offs are nothing more than a healthy Bull-market correction. Such corrections are great opportunities for traders to buy the dip. However, once Stage 7 begins the buy the dip strategy usually becomes futile since dips are no longer followed by impressive rallies, but instead are followed by further dips.
Traders stuck on the buy-the-dip mentality are the ones who can be most surprised by the intensity of selling when Stage 7 begins. Their collective surprise can show up when they are ultimately forced to cut their losses. Buy-the-dip traders are forced to capitulate when Stage 7 makes the strategy difficult or impossible. Capitulation is often evident when Stage 7 reaches maturity – when the S&P 500 enters the violet zone on the chart.
The Covered Call/Naked Put Index (#CCNPI) verifies the current bearish sentiment in the stock market, which by now should be obvious to most everyone.
The Long Call/Married Put Index (#LCMPI) continues to show weakness among the Bulls, and their lack of confidence. Such weakness is what puts a cap on market rallies.
The Long Straddle/Strangle Index (#LSSI) is again within normal limits, indicating that any broad-based major breakout in stock prices or any major reversal of the recent bearish trend is likely to be news driven. That is to say, such a move is not likely to come out of the blue, as it can when the #LSSI is outside normal limits. If the S&P makes any major moves in the next week or so, it will very likely come as a result of some sort of news that acts as a catalyst.
Once Stage 7 becomes entrenched, it is very difficult for the S&P to return to a bullish trend without first sinking deeper into bearishness. The return of the Bull market rarely occurs until Bear Market Stage 8 has wreaked havoc on stock prices, once Stage 7 has begun.
* 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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