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 -110

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.

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 Temperature

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 09-03-15

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 09-03-15 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 09-03-15 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).

#CCNPI – The S&P 500 Covered Call/Naked Put Index

 CCNPI 09-03-15

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

LCMPI 09-03-15 

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

 LSSI 09-03-15

Market Summary

As referenced here last week, traders should be on the lookout for two major indicators in the options market in coming weeks.

  1. If the S&P 500 Temperature remains below zero a Bear market has likely taken hold and stock prices would likely eventually fall far enough to meet the traditional Bear-market threshold of a 20% decline off the highs.
  2. If the S&P 500 Temperature subsequently fails to exceed +125 after spending several weeks below zero, chances are quite low that the Bull market uptrend will resume without first undergoing a 20% or greater decline in stock prices.

The S&P 500 Temperature has now been continuously below zero since August 21. The current stretch of sub-zero Temperatures has now surpassed the most recent occurrence – a rather brief 9 day stretch in October 2014.

Furthermore, the intensity of the cold is much more notable this time around. Although the Temperature of -91 that occurred intraday back on October 15 was brutal, it pales in comparison to the recent low Temperature of -191 reached on August 24 and again on the 25th.

The intensity of the cold is an important factor, because as traders become acclimated to such a harsh environment, it affects the way they tend to trade in the near future. The October dip in stock prices was certainly severe, but it never reached the severity of the past two weeks. Traders at that time had been conditioned to buy the dip, no doubt prompted by years and years in which every dip in the S&P seemed to lead to a rally to new highs.

It is still possible that the current dip is just another one of those many dips that will lead into new record highs. Anything is possible, in theory. However, the intensity of the cold this time around, has likely scared a lot of traders, or at least made them re-consider their tolerance for risk. Also, the duration of the cold is likely starting to take a toll as well.

Given the greater intensity and the longer duration, some traders will decide to exit the stock market on the next rally, particularly if stock prices broadly climb to near their peaks achieved back in July. If the S&P 500 re-tests its all-time high near the 2130 level, some traders will thank their lucky stars they got back all the profits they lost during the past several weeks.

How many traders will exit? There is no way to know for sure. But one thing that is a sure bet is that the colder the S&P 500 Temperature gets, and the longer it remains below zero, the more traders there will be with plans to exit their long stock positions if the S&P re-tests its record high.

As can be seen in the chart of the Options Market Stages above, the S&P 500 has entered a zone in which bearish emotions are widespread. There really is no way of proving or disproving the existence of a Bear market, except in hindsight. However, the current environment has all of the necessary ingredients. If this truly is the beginning of a new Bear market, then the number of bearish traders exiting their stocks on rallies will limit the upside potential for the S&P 500.

The very definition of a Bear market is one in which upside potential is limited. Once the upside is capped, the market will eventually seek the downside. After all, stock prices can’t go sideways forever. Stock prices absolutely must have the ability to go up, or else they will go down eventually.

A Bear market is simply one in which the reward of stock ownership (from increasing share prices) isn’t worth the risk (of declining prices). Take away the reward, and all that remains is the risk. It’s as simple as that. So, the lower the S&P 500 Temperature falls below zero, and the longer it remains below zero, the lower the perception of reward will become in traders’ minds.

At some point in the coming weeks, the S&P 500 will likely put in a bottom, perhaps a temporary bottom, but a bottom nonetheless. That very bottom may have already occurred, or it may still be a ways off. There is no way of knowing for sure. But, there is almost always a bottom within several weeks of the first thrust down in stock prices – even during major crashes.

Historically, during the first thrust down of a new Bear market, the S&P 500 has tended to hit its first major bottom when it is in the violet zone. That is where Bear Market Stage 5 tends to reach full maturity. Bear Market Stage 5 is known as the “Oh No!” stage because of the sense of surprise at the bearish change in the overall trading environment. When Stage 5 reaches full maturity, the environment often shifts quickly, almost reversing the bearish sentiment.

When that bottom occurs, the market will need to test traders’ confidence. To do so, stock prices will need to climb, and they will need to climb to impressive levels. Generally, the Temperature tends to climb back above zero during such a rally, if only temporarily. Once the Temperature has exceeded zero, the market has confirmed that it has shifted to Bear Market Stage 6. That stage is known as the “Phew!” stage for the collective sigh of relief.

What makes the “Phew!” stage dangerous is that many, many traders likely have plans to exit, even as stock prices are climbing impressively. If it truly is a Bear market, too many traders will exit and the rally will eventually fall apart. Historically, as long as the S&P 500 does not exceed the point at which Long Call trading* becomes profitable, the rally will eventually crumble.

In the charts of the Options Market Stages above, the orange line at the top of the orange zone marks the dividing line between Long Call profits and Long Call losses. Thus, the orange line marks the limit of any dead-cat bounce in a Bear market (if it truly is a Bear market, which won’t be known conclusively until it can be seen in hindsight). On the first chart of the Options Market Stages, the orange zone is depicted as a Bull-market “correction (Bull Market Stage 4) while the second chart depicts it as a dead-cat bounce (Bear Market Stage 6). That’s because a Bull market can go into a correction, either with or without entering a Bull market; but, a Bear market cannot turn back into a Bull-market correction.

A true Bear market cannot turn back into a Bull market until it has gone through the entire Bear market process. That entails the traditional 20% or greater widespread decline in stock prices. A true Bear market cannot do anything except bounce to the orange line. If for some reason the S&P 500 bounces above the orange line, then something is adding momentum; it’s not just a bounce, and it therefore is not a Bear market.

* 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

Related Options Posts:

S&P Options: Bear Market Until Further Notice

Thursday Evening Options Brief 2015-Aug-13

Option Strategies for Range-Bound Markets

 

Leave a Reply

You must be logged in to post a comment.