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 89

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 Oct 292015 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 10-29-15

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 10-29-15

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 10-29-15

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

LCMPI 10-29-15 

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

 LSSI 10-29-15

Market Summary

This week’s stock market is so much like a textbook version of Bear Market Stage 6 that it is noteworthy. Traders who follow the Options Market Stages should bookmark this week for future reference and refer to it when Stage 6 occurs again at a later date.

To quote from the definition of Bear Market Stage 6 shown on the Options Market Stages chart above:

Stock prices have bounced off of lows, but implied volatility (VIX) is high. Profitability of Covered Calls and Naked Puts is bullish, but Long Calls and Married Put losses indicate no bullish strength. Long Straddle and Strangle losses signal a possible upcoming breakout, usually to lower prices.

Stock prices certainly have bounced off of lows that were put in just a few weeks ago when the S&P had dipped into the mid-1900s. Volatility is not very high, though. That’s simply a result of Stage 6 representing a rather changeable environment – ranging from fears of an impending dead-cat bounce to euphoria of what can appear to be new record highs. The VIX can certainly be high at times during Stage 6. But, the fact that the VIX is not extremely high at the moment, currently hovering near 15 or so, does not, on its own, invalidate the presence of Bear Market Stage 6.

Traders who want to be prepared for Bear Market Stage 6 to be invalidated should look to the S&P 500 Temperature as a reliable gauge. A Temperature above +75 is a signal that traders should start getting prepared. A Temperature above +125 is a reliable alarm, particularly if the Temperature remains above that level for more than a week or so.

Perma-Bulls, and indeed any trader who is having difficulty embracing a bearish outlook at the moment, can look for a Temperature above +125 for validation and a sense of comfort. Perma-Bears and others who find a bearish easy to embrace at the moment can look to a Temperature that fails to make it to +125 as a confidence builder.

As for the three types of option strategies presented in the analysis, beginning with Covered Calls and Naked Puts – these trades* are now profitable on $SPY. That’s usually a bullish sign. In fact, Covered Calls and Naked Puts are profitable whenever the S&P 500 Temperature is above zero. Indeed the Temperature is well above zero right now.

Next, Long Calls and Married Puts – these trades* are not profitable right now. That’s a sign there is no bullish strength. Traders are not confident yet, despite the recent rally in stock prices, no matter how bullish they may profess to be.

Finally, Long Straddles and Strangles – these trades* are highly unprofitable at the moment. That’s usually a sign that the market is getting ready for a major breakout from the trading range of the prior few months. While a breakout can occur in either direction – a major rally or a major sell-off – the tendency during Stage 6 is for the breakout to occur as a major sell-off.

Regardless of the direction of the breakout, now that Long Straddle losses have reached such an historically high magnitude, chances are very good that a major breakout will occur in the next several weeks. The implications of the imminent nature of the breakout are that within the next several weeks the Bull market of the past six years will resume in earnest or else the Bear market trend that began a few months ago will become much more pronounced.

On the chart of Stocks and Options at a Glance, the “You are Here” sign shows just how precarious the position of the S&P 500 tends to be during Stage 6. Should the environment continue in a textbook manner, the next sell-off, should it occur, would likely be much steeper and deeper than sell-offs which occurred in the past few months.

Also on the Stocks and Options at a Glance chart, the current combination of profitable and unprofitable option strategies can be seen. A+ denotes the profitability of Covered Calls and Naked Puts. B- denotes the lack of profitability of Long Calls and Married Puts; and C- denotes the lack of profitability of Long Straddle and Strangle trades.

The lack of profitability of Long Straddles and Strangles also shows up on the chart of the #LSSI index. The chart of the #LSSI is particularly interesting this week. Rarely does the #LSSI sink below -6%. Historically, major breakouts in stock prices have occurred within several weeks from the first time the #LSSI sunk below -6%.

* 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


Related Options Posts:

Welcome to Bear Market Stage 6

Thursday Evening Options Brief 08-Oct-2015

Thursday Evening Options Brief 24-Sep-2015

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