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.
A 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 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
Let’s start with the Temperature; it is now bitterly cold once again. While it is not quite as cold as it was just a few months ago, in September and October, it is still mighty cold by historical standards.
Looking at the Historical Temperature, the S&P 500 only got as cold as it is currently… way back in the mini-Bear markets of 2011 and 2010 and during the Financial Crisis of 2008 and 2009. Perhaps obviously, an S&P Temperature of 40 or 50 below zero does not bode well for rising stock prices.
The correlation between Temperature and falling stock prices is fairly simple. It takes some doing to push the Temperature below zero – which is the point at which Covered Calls* no longer return profits at expiration.
When Covered Calls are no longer giving option traders profits, we can bet that most traders in the stock market have long since lost confidence. That’s because stocks can lose value for weeks, sometimes months, as Covered Calls keep returning profits. When Covered Calls begin to show losses for option traders, stock traders are often already weary from losses.
Not only are stock traders getting weary now, this is the second time it has gotten this cold in the past six months or so. The first bout was associated with Bear Market Stage 5. This current bout, coming so soon after the first, will tend to affect traders more deeply. Traders who got fooled by the downturn in August, September and October are going to defend themselves this time around. “Fool me once shame on you, fool me twice shame on me” they will say.
Technically, any Temperature below zero can usher in Bear Market Stage 7, though it often comes in with Temperatures of -75 or lower. The current Temperature of -46 is close enough to the guidelines of -75 as to suggest Stage 7 is here to stay for a while.
The chart of Stocks and Options at a Glance shows the probable location of the S&P 500 in Bear Market Stage 7. While this chart suggests stock prices will generally trend lower in coming weeks or months, it is not meant to be predictive. Anything can happen in the future. Instead it is intended to show how stock prices have performed in the past given a similar trading environment as the present one.
The Options Market Stages chart fits nicely this week with past instances of Bear Market Stage 7. In fact, the current chart is almost a textbook example for the progression of a Bear Market.
Finally, we have the charts of the #CCNPI, #LCMPI and #LSSI. The #CCNPI is decidedly bearish. That likely comes as no surprise to anyone who has traded stocks lately.
The #LCMPI shows the amount of weakness present among bullish traders. Again, most active traders can probably sense the amount of weakness and the lack of confidence. But a glance at the #LCMPI shows just how long such weakness has existed – since approximately May of 2015, well before the meltdown that happened in August.
Furthermore the #LCMPI has been in a broadly declining pattern since the most recent Bull market began back in 2009. That is to be expected with any Bull market. Bullish strength declines over time as a Bull market matures. What the #LCMPI does is give traders a visual depiction of the decline. Following the peaks of strength from 2009 forward, it should have been obvious that at some point in 2015 or 2016 that strength would disappear completely.
This chart, published in January 2015 shows the trend for the #LCMPI very well. When the upper red line declines so far that bullish strength is no longer possible, the only thing left is weakness. That’s when a mature Bull market has run out of time. It almost always takes a Bear market to clean the slate and make room for a new Bull market.
The #LSSI is normal this week. That means there is no compelling reason for stock prices to suddenly reverse the recent downtrend, nor is there any reason for stock prices to suddenly jump outside their range of the past few months. It does not mean stock prices won’t suddenly reverse higher or won’t suddenly break out of their range. It just means that there is currently no compelling reason from an option-trading standpoint.
World events, economic news and the like, always have the ability to cause stocks to move, even if the #LSSI is normal. When the #LSSI is abnormal – that’s when moves can occur without any catalyst at all.
So, it looks like Bear Market Stage 7 is here, given all the evidence. That would suggest more sell-offs coming in the near future. Rallies in Stage 7 tend to be short-lived, and often lead to even lower stock prices… eventually. Rallies, short-lived though they may be, can be impressive, especially when short-sellers are forced to buy stock to cover their short positions. The overall trend tends to be to the downside as long as Stage 7 is in place. It does not take too long for the outlook to become bleak – and that’s when Stage 8 begins. Just something to look forward to if the status quo continues.
* 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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