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 53

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 Nov 26 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 11-26-15

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 11-26-15

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 11-26-15 

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

LCMPI 11-26-15 

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

LSSI 11-26-15

Market Summary

There are many patterns that can form on charts of stock prices. Some of those patterns occur often enough to be easily recognizable among traders. Of the more recognizable ones, some provide valuable insight.

Although it is true that stock prices can move randomly, and thus produce meaningless patterns, it is also true that patterns are not always randomly generated. For example, some stock price patterns are very telling of the sentiment of traders. Therefore, when the pattern ultimately ends, as all patterns do, a trader who notices the change in pattern can often turn that observation into a prediction.

That’s not to say that pattern recognition allows traders to predict the future. Rather, an observant trader can recognize shifts in sentiment that accompany the pattern shift, and make an educated guess regarding the future based on similar shifts in the pattern that have occurred in the past.

One such pattern is the cup-and-handle. As one might imagine, the cup and handle gets its name from the pattern the stock price forms on a chart. When the stock price is plotted each day, from left to right, the cup shape forms first, followed by a handle near the top right of the cup. The result is something resembling a tea cup.

cuo and handleThe bottom of the cup itself is formed when buyers step in to push the stock price up after it has declined somewhat. The bottom thus signifies support. Support is always a result of bullish sentiment, since it takes bullish traders to step in and buy stock during a downturn.

The handle of the cup signifies resistance and indecision. Since the handle forms from a sideways or slightly downward move after a recovery from the bottom of the cup, it indicates the point at which traders are undecided (as a herd) whether the stock price has the ability to climb above the top of the cup or whether the top of the cup is the upper limit at the moment.

The problem many traders encounter when they see a cup-and-handle is that the handle doesn’t necessarily have any time constraints. In other words, “when does the handle get so long that it is no longer a cup-and-handle pattern?” There is no definitive answer. However, options may offer some help in this regard.

When a cup-and-handle pattern forms, the handle of the cup will often occur within a specific Options Market Stage. The recent S&P 500 cup and handle resulted in the handle occurring inside Bear Market Stage 6. Thus, one way of gauging the validity of the current cup-and handle formation is to assume that it remains valid as long as the handle stays within the same Options Market Stage. If the handle goes outside of Bear Market Stage 6, the cup-and-handle pattern is likely no longer valid.

Since the end of the cup-and-handle marks a shift in sentiment, just as the end of any pattern marks a shift in sentiment, a trader who recognizes the shift may make an educated guess regarding the future.

If the current cup handle on the S&P 500 moves into Bull Market Stage 0 it would likely mean a shift to much more bullish sentiment and thus rising stock prices. In many cases a cup-and-handle is considered a bullish pattern. However, traders often struggle to recognize the verification of bullishness when it does indeed occur.

There are many methods of verification, but perhaps none as simple as the Options Market Stages. The moment the cup handle moves above its current stage, that is a strong indicator that bullishness has been verified. Since the boundary line for the stage shifts over time, the trader need not make any complex calculations. All that is necessary is to look for the handle to cross the line.

If the cup handle on the S&P 500 goes below the limit of Bear Market Stage 6, into Stage 7 or Stage 8, then the cup-and-handle pattern would no longer be valid as a bullish indicator. Any hopes of bullishness are lost at the moment the handle breaks.OMS 11-26-15 Cup and handle

As can be seen on the chart of the #LSSI (S&P 500 Long Straddle/Strangle Index) the #LSSI has reached a point that typically precedes a major breakout in price for the S&P 500 as a whole. When the #LSSI is at or near extremely low levels, typically -6% or lower, it often coincides with anxiety among traders regarding feelings that the stock market has become stuck in a rut, and is too range-bound for their comfort. Traders like trends, because trends are recognizable. But choppy range-bound markets bring anxiety.

When the #LSSI is indicating a collective desire among traders to push the S&P out of its current range – a major breakout – then a breakout often occurs. It becomes a sort of self-fulfilling prophesy as traders desire a breakout, then over-react to news and other catalysts, ultimately bringing about the breakout they so desired. In the current environment, with the cup-and-handle pattern existing on the S&P 500 chart, the breakout would likely result in the end of the pattern and thus mark a significant shift in the trading environment of the past several months. The breakout would either verify the bullish cup-and-handle pattern or else invalidate it completely.

* 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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Sneak Peek at 2016 Options Market Stages

Option Alternatives for Stop and GTC Orders

More to Options than Covered Call Trading

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