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 -28

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 Mar 10 2016

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.

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 03-10-16

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.

Progression of Bear Market Options Stages 2015

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 03-10-16

10 Year History of the above chart (showing all bullish stages) is now available. The 10-year chart is also available with bearish Stages only.

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

CCNPI 03-10-16 

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

 LCMPI 03-10-16

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

LSSI 03-10-16

Market Summary

“You can’t have a sustained uptrend in stock prices unless Long Call option trading is profitable”. That quote is one of the two most basic correlations between stocks and options – the other being that stock prices will trend down as long as Covered Call trading is unprofitable (we’re talking about expiring options opened ATM 4-months to expiration).

Currently, the S&P 500 is exhibiting both of those qualities:

  • This week’s expiring $SPY Long Call options opened at-the-money on November 20 (4-months ago) are not profitable.
  • This week’s expiring $SPY Covered Call options opened at-the-money on November 20 are not profitable.

The implication of the performance of those expiring options is that the stock market environment is currently not conducive to a sustained uptrend because Long Calls are not profitable. Furthermore, the trend for stock prices is currently to the downside based on the fact that Covered Calls are not profitable.

Until one of those two things changes, the stock market is going to remain in its current rut – rallies will fizzle out after a few days or a few weeks, stocks will struggle higher only to make lower highs than they used to make, often followed by a pull-back off those highs that sets lower lows.

To state it another way – it’s a Bear market until Covered Calls become profitable again; and even then, even if Covered Calls do become profitable it is likely still a Bear market until Long Calls start returning profits.

Since it can be cumbersome for a trader to follow the outcome of a bunch of option trades, the S&P 500 Temperature can be a valuable yet simpler indicator.

When the Temperature is above zero, Covered Calls are profitable, by definition (always, without exception). That’s the first sign of a Bull market. Profitability of Covered Calls is an indication that the overall trend for stock prices is to the upside. To be a sustainable uptrend though, the Temperature must hit +125 or higher.

When the Temperature is above +125, Long Calls are generally profitable (not always, but generally, as a rule they are profitable). That’s an almost irrefutable sign of a Bull market. Profitability of Long Calls is an indication that not only is an uptrend in progress, but sentiment among traders is bullish as well.

It can be said, therefore, that a Temperature above +125 is achieved only when a Bear market is safely distant in the rear-view mirror. To illustrate this, we can look to the chart of the #LCMPI. The S&P 500 Long Call/Married Put Index depicts the profitability or unprofitability of Long Call options on $SPY. Thus, a positive value for the #LCMPI tends to correlate with a Temperature of +125 or higher. Essentially, whenever the #LCMPI pops back above zero, the Bear market is in the rear-view mirror. That’s when bullish “strength” can be observed.

Here in early March of 2016, Covered Calls are not profitable. The S&P 500 Temperature continues to be below zero. Thus, the first sign of the Bull market’s return has not yet been seen. Additionally, on the rare occasions when the Temperature has indeed risen above zero recently, it has not gotten anywhere near +125. Long Call trading has been and continues to be unprofitable.

“You can’t have a sustained uptrend in stock prices unless Long Call trading is profitable”. That’s why every rally seems to fizzle these days. A look at the chart of the #LCMPI shows just how long this has been going on – since May 22, 2015 – that’s the last time Long Calls expired with a profit. That’s also the last time the uptrend was sustainable.

Ever since May 22, 2015 the uptrend has been unsustainable. It will remain unsustainable until Long Call trading becomes profitable again, until the S&P 500 Temperature rises above approximately +125, until the #LCMPI becomes positive, until the Bulls start showing their strength once again.

* 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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Related Options Posts:

Thursday Evening Options Brief 25-Feb-2016

Thursday Evening Options Brief 18-Feb-2016

Historical Bear-Market Option Performance

 

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