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.

SNP Temperature 203

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.

Points Above Bear Dec 10 2015 minus 100

A historical 10-year chart of the S&P 500 Temperature 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.

Options Market Stages S&P 500 Temperature1

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.

 Stocks and Options at a Glance 12-10-15

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.

Options Market Stages

Click on chart to enlarge

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.

OMS 12-10-15

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 over-extended (and needs to back off a little, or “correct”), 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 correction nor in need of a breakout). It should be noted that a correction during a downtrend usually entails rising prices, and is the reverse of a correction during an uptrend which usually entails a decrease in prices.

#CCNPI – The S&P 500 Covered Call/Naked Put Index

CCNPI 12-10-15 

#LCMPI – The S&P 500 Long Call/Married Put Index

 LCMPI 12-10-15

#LSSI – The S&P 500 Long Straddle/Strangle Index

 LSSI 12-10-15

Market Summary

Every trader needs a good system of checks and balances to ensure the market is not misleading him. A check and balance can be as simple as a mentor or another trader with whom a trader can share ideas. The primary purpose of the second trader is to warn the first trader when he sees the first trader making a potential grievous error.

In much the same way, stock-market indicators require a means of checks and balances. No indicator can be reliable all the time; so it is a good idea to have at least one other indicator handy, if for no other reason than to set off the warning bells when the first indicator could be grievously misleading.

Such is the case this week with the S&P 500 Temperature. Currently the Temperature is screaming “Bull Market!”, “Euphoria!” and “Lottery Fever!”. When the Temperature is high, particularly when it surpasses +125, it is often an indicator of extreme bullishness among traders. If one were to base one’s trading on the Temperature alone, the current environment would appear to be among the very greatest buying opportunities the stock market can offer.

The design of the S&P 500 Temperature causes it to be prone to failure as an indicator during periods of high implied volatility. Since the Temperature is based on expiring options that have been open for four months, indicator failure tends to lag the market by four months. The period of high VIX and high volatility that occurred this past August is just now being reflected in the current S&P 500 Temperature here in December.

The S&P 500 Temperature is not necessarily incorrect at the moment – it could be dead-on correct – but it is simply not reliable at the moment. That’s where the checks and balances come into play.

The Options Market Stages chart clearly shows the S&P 500 remaining inside the boundaries of Bear Market Stage 6 at the moment. That’s a stark contrast to the euphoric Lottery Fever environment indicated by the S&P 500 Temperature.

Which indicator is correct? There is no way of knowing for certain. Certainly the vulnerability of the Temperature to elevated implied volatility suggests the Temperature may be useless as an indicator at the current time. But, one cannot categorically ignore an indicator that has proven to be very accurate over a long period of time, as has the Temperature.

Perhaps the best one can garner from the contradicting signals for the S&P 500 Temperature and the Options Market Stages is that they are presently in conflict. If the indicators are in conflict, it stands to reason that traders can sense a similar conflict in their own minds.

Intense conflict often leads to wild swings in the stock market. Major breakouts in stock prices tend to revolve around major conflict within traders minds and emotions. This conflict can be further illustrated by the #LSSI – the S&P 500 Long Straddle Strangle Index.

The #LSSI has reached another extreme, surpassing the -6% limit that quite often precedes a major breakout in stock prices. Although the #LSSI does not predict the direction of the breakout, it can be a warning bell for traders that something big is likely to happen soon that will push stock prices out of their range of the past several months.

A major breakout can make a trader a lot of money in a short period of time. Many traders may view the current environment as an opportunity for quick gains. But those gains can just as easily be quick losses if a trader takes the wrong side of the trade. The specter of an upcoming breakout is just as much an opportunity to sit on the sidelines in cash as it is an opportunity for profits. Folks on the sidelines may regret missing huge profits, but by the same token they may count their blessings if they miss out on huge losses.

* 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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