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.
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
Rallies are not uncommon during Bear-market downtrends. What often differentiates a Bear-market rally from one that occurs during a Bull market is that the Bear-market rally is usually just a relief of built up stress rather than a sign of the overall trend.
When the trend is to the upside, as it is during a healthy Bull market, rallies are common; they are also in line with the uptrend.
A rally in a Bear market goes against the trend. Thus there are only two things that a Bear-market rally implies:
- The stock market was oversold and in need of a temporary reversal of the downtrend
- The Bear market has reached its bottom and a new bullish trend has begun
Since it can be difficult or impossible to tell the difference between the two scenarios, traders may become frustrated and anxious during Bear-market rallies. They may ask themselves “Is this an opportunity to sell the rip?” or “Should I join the party now, and start buying stocks?”
Obviously only one of the questions can be answered: yes. The problem for many traders is that determining the answer may come down to flipping a coin; and for those who despise trading based on a coin toss, taking a seat on the sidelines may be the only recourse, with trading capital parked safely in cash.
To some, an options analysis may be better than a coin toss. Since there are only two scenarios that follow a Bear-market rally, the analysis is rather simple and straightforward.
If the stock market is just oversold and needs a temporary reversal to eliminate the oversold condition, then the #LSSI index should have indicated that the market was “due for a reversal”. Indeed the #LSSI recently generated such an alarm on February 11 – just one week ago.
A chart of the #LSSI as it appeared on February 11 can be viewed HERE.
The full analysis of the #LSSI is available HERE.
In that analysis, it was noted that: “Since the #LSSI is currently at such an extreme high, an impressive rally-off-the-low for stocks would not come as a surprise.”
The recent rally, from the perspective of the #LSSI, is nothing more than the alleviation of an extreme condition in the market. Stock prices declined too far, too fast, for the downtrend to be sustainable. Thus, a temporary reversal of the downtrend – a rally – is just a way of slowing down the trend so that it is more sustainable.
If that’s all it is, then the rally should be temporary. If so, then the options should offer other signs that also suggest the rally is temporary. Here are a few worth considering.
- The S&P 500 Temperature remains far below zero, despite the recent rally. Being a very conservative measure of bullishness it is noteworthy that even such a conservative measure is nowhere near being bullish at the moment.
- The chart of Stocks and Options at a Glance continues to suggest the stock market is in a Bear market (at Bear Market Stage 7). Based on option performance of Covered Calls, Long Calls and Long Straddles, the S&P 500 matches historical bearish environments much more than bullish ones.
- The chart of the Options Market Stages shows just how insignificant the recent rally was. There has been little change in the bearish outlook in recent weeks even though the S&P is more than 100 handles off of recent lows.
- The Covered Call/Naked Put Index (#CCNPI) remains bearish.
- The Long Call/Married Put Index (#LCMPI) continues to show weakness and no sign of bullish strength.
Given the evidence, it would appear for now that the recent rally did nothing more than eliminate an oversold condition in the S&P 500. Now that the condition has been eliminated, the Long Straddle/Strangle Index (#LSSI) has returned to normal. Thus there is no imminent need for a continued reversal of the overall downtrend.
Should stock prices continue to climb now, it would not be due to such an imminent need, but for other reasons. All a trader needs to do now is keep an eye on the Temperature and other option indicators.
If the recent rally was a simple stress reliever for the market, it will lose strength and eventually fizzle altogether. That would likely occur prior to the Temperature reaching +125, before Long Calls become profitable again, before the S&P 500 enters the black zone on the Options Market Stages chart and before the #LCMPI turns positive.
Should the rally somehow turn out to be the start of a new Bull market uptrend for stocks, the rally would quickly push the Temperature above +125, Long Calls would become profitable, the S&P 500 would enter the black zone and the #LCMPI would turn positive again.
As always, the options analysis is not so-much intended to predict which scenario will occur, but rather to identify each scenario clearly so that traders can recognize it when it arrives. That’s how traders gain an edge in the market.
* 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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