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 -95

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 Sep 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 09-24-15

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.

 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 09-24-15 Bull

10 Year History of the above chart is now available.

Since the S&P 500 has now entered a bearish environment, it can be helpful if we adjust the chart above to include only the Bear market stages.

 OMS 09-22-15 Bear

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 09-24-15

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

 LCMPI 09-24-15

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

 LSSI 09-24-15

Market Summary

Any time the S&P 500 Temperature is below zero, there is a high probability that a Bear market is underway. Even if stock prices have not broadly declined by 20% – the widely accepted definition of a Bear market – the fact the Temperature is below zero suggests prices will eventually decline far enough to meet the 20% threshold.

Additionally, the longer the Temperature remains below zero, and the further below zero it drops, the greater the chances that stock prices will eventually fall 20% off their recent highs. Particularly compelling is the evidence that in past decades Temperatures below -100 have always been associated with a decline of 20% or more. The most recent ten-year chart of the Historical S&P 500 Temperature, shown above, shows the correlation quite well.

Since the Temperature has already fallen below -100 several times since August 21, 2015, should the pattern of the past ten years continue, the S&P would be expected to meet the 20% threshold for a Bear market sometime in the next few months.

Typically there is at least one major bounce in stock prices prior to the S&P crossing the 20% threshold. Rallies can be impressive when folks who have shorted stocks are forced to buy those same stocks in order to cover their short positions. Additionally, since the recent drop in stock prices has only occurred recently – in the past month or so – plenty of buy-the-dip types of traders are still waiting to buy this current dip.

The combination of buy-the-dip demand for stocks often combines with a short-covering rally to form a dead-cat bounce – a temporary rally in an otherwise downward trend for stock prices. Such a rally does not always occur, but should it occur in the next several weeks it would be evidence that the S&P 500 has moved from its current stage “Oh no!” (Bear Market Stage 5) into the next “Phew!” (Bear Market Stage 6)

A Bear market thrives on a complete loss of hope and confidence. Such hope tends to remain until it is dashed completely. There are generally only two ways that traders can give up hope completely:

  1. Stocks can rally (a dead-cat bounce) only to have the rally fail, proving that the Bull market is truly dead.
  2. Stock prices can remain depressed for a month or a few months, but ultimately fail to rally back to previous highs, proving that there is no hope the Bull market will return anytime soon.

When the hope disappears completely, then the S&P is ready to move on to Bear Market Stage 7 – the “look out below” stage. Soon afterward, the Bear market tends to become fully mature, and enters Bear Market Stage 8 – the “bleak outlook” stage. In the chart of the Options Market Stages above, the blue zone represents Stage 8.

Though not entirely impossible, Stage 8 is rarely reached until all hope has been lost. In the two scenarios above, that describe ways in which hope can be lost, there is a similarity. In each scenario, the S&P 500 tends to move into the orange zone on the chart but fail to move above the orange zone. That very failure, the inability to climb out of the abyss of the orange zone, coincides with the loss of hope.

The result is that new Bear markets rarely enter the blue zone (Stage 8) until after the orange zone (Stage 6) has failed to drive the S&P out of the abyss. In other words, the S&P will often enter the violet zone but many times it won’t enter the blue zone until it re-enters the orange zone at least once. Or, quite simply, blue follows orange… most of the time anyway.

* 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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