By Chris Ebert

go back 3 spacesWith the S&P 500 closing near its all-time record once again, now is a great time to evaluate whether the stock market has reached a top, or whether it is about to rocket much, much higher. It would be terrific if there was an easy answer, but there is not. There never is. That is what makes tops so dangerous – dangerous to buy because the bottom could fall out – dangerous to short because the top could blow off.

Perhaps the most important question a trader can ask right now is:

” Whether the S&P rallies explosively, or whether it crashes in coming months, is it likely that the S&P will never again return to its current level (2130ish)?”

Depending on the individual trader’s answer, there are a number of ways to play the current market. For those who believe 2130 will soon be left in the dust, with the S&P never making a return to that level, the choices are quite restricted: Bullish traders who think the S&P will never again fall to 2130 pretty much have to buy stocks right now; either that or buy Call options or sell Put options.

For traders who think the S&P has topped out in the 2130s, the choice is equally restrictive: sell stocks or short them, sell Call options or buy Put options.

But, is it realistic to suppose that the S&P will never again return to the 2130s? Given historical performance, such a supposition is likely to be flawed. The S&P tends to return to previous levels often. The only levels for which a return is not a high probability are very low levels that were left behind many, many years ago. For example, a trader who is betting on a return to SPX 800 is likely delusional; for even if it was to occur it could be years away, with that trader likely missing thousands of opportunities to profit while waiting.

A return to the 2130 level is actually quite a high-probability event. It does not matter whether the stock market rallies higher from here or whether it crashes lower; either scenario is almost certain to see a return to the 2130s at some point in the coming months. That’s good news for traders – all traders, long or short – because it provides hope that any losses suffered from today forward could be temporary if the trader acts appropriately.

SNP

A trader who goes short when the S&P Temperature is this hot is taking a risk. Stocks are hot right now, so it isn’t likely there will be any major sell-offs without a significant news catalyst to spark such a sell-off. It doesn’t mean it can’t happen – nobody knows tomorrow’s news, and tomorrow’s news could just as easily be bad as it could be good – just that without bad news stock prices are not likely to plummet. Nevertheless, no matter how far stocks rally, it is a pretty good bet that the S&P will at some point return to its current level, perhaps on a dip, perhaps on a test of support. Who knows what the reason will be? The important thing is that even if a trader goes short and suffers losses, there will likely come a point to bail out of those trades when the S&P returns to the 2130s.

The same is true of a trader who goes long now; declining economic conditions, no matter how severe, would not likely preclude a return to the 2130s for the S&P at some point in the future. As long as a trader is willing to hold long positions through weeks, perhaps months, of unrealized losses, it is highly probable that the S&P will return to the 2130s and give the trader an opportunity to exit without a loss.

SNP Temp2

The S&P 500 Temperature rarely gets as hot as it is today. The chart above shows just how seldom it reaches the boiling point (Temperature of 212). The implications are that the S&P can handle a tremendous sell-off at the moment, but without necessarily taking on bearish tendencies. The S&P could decline 10% from its current level in a short period of time and the options market would not suffer any losses that would be considered bearish. Most notably, $SPY Covered Calls opened at-the-money 4 months ago would not suffer losses if the S&P suddenly experienced a 10% decline, even if that decline came in a single trading session. That’s one mighty argument for being bullish right now.

Unfortunately, there is an argument for the Bears now as well. That argument is that the S&P is having trouble attaining the upper Options Market Stages. It had no trouble achieving Lottery Fever several times a year for many recent years. But, it has yet to experience a single case of Lottery Fever in 2015. That’s not good news for long-term continuation of the recent bullish trend. It is good news for Bears who are contemplating shorting the recent rally.

OMS 05-21-15a

Regardless of whether the recent hot S&P 500 Temperatures tend to make a trader want to buy, or whether the remarkable lack of Lottery Fever makes a trader want to short this market, there is comfort in knowing that whatever the choice, if the choice turns out to be incorrect there will probably come a point to exit the trade when the S&P returns to the 2130s, which it almost certainly will do.

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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