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.

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 (showing all bullish stages) is now available. The 10-year chart is also available with bearish Stages only.

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

Market Summary

When we look at the current S&P 500 Temperature, we see how bearish the current trading environment truly is. For weeks, the Temperature has hovered in the hundred-below-zero area.

When the Temperature is this low, it causes traders to take profits quickly whenever there is a rally higher for stock prices. The Temperature doesn’t prevent rallies from occurring; it merely puts a hurdle in the way of each rally.

A rally during sub-zero Temperatures must have extraordinary support from extraordinarily large institutional traders or else it will stumble over one of the hurdles. To look at it another way, if stock prices continue to rally without stumbling over a hurdle, then extraordinary support from extraordinarily large traders can be inferred.

That’s one mighty important inference, because if stock prices are being pushed higher by big institutions, the individual trader must ponder the reasoning for the push. Why does anyone push stock prices higher? Great corporate fundamentals? A strengthening economy? Foreseeable loosening of monetary policy?

Those are all good reason for big institutions to devote more capital to stocks, in turn pushing stock prices higher. But absent those reasons there is really only one motive for institutions to push stock prices higher – because they are planning to sell, sell, sell.

Whenever anyone has something to sell, there is a motive to make that something appear more desirable. The more desirable, the higher the sale price, theoretically. It’s why homeowners add a new coat of paint before planting a for-sale sign in the front yard; and it’s why big institutions push for a nice shiny rally when they have a desire to sell large blocks of stocks.

It’s easy to rationalize a stock market rally and find plausible reasons for it. One can blame the rally on anything – literally anything. Perhaps it’s stabilization of oil prices, perhaps a cure for Zika virus has been discovered. But despite being plausible, there is always a chance that the rally is nothing more than a means to higher stock prices for those who want to sell stocks.

How high can the rally go before it’s something more than just a way to artificially inflate prices? The chart of the Options Market Stages says the S&P cannot go out of the orange zone in an artificially inflated Bear-market environment.

If the S&P does get into the black zone, the rally to get there was likely based on improving economic fundamentals. Big institutions would have taken profits long before the black zone was reached; there would have been plenty of distribution days if the rally was artificial. Widespread distribution would serve as a hurdle to entering the black zone if the rally was artificial.

At the moment, an artificial rally to the 2100-ish level is not out of the question for the S&P 500. That’s how high the S&P can go without escaping the orange zone on the chart. That’s how high the S&P can climb without going outside the boundaries of the current Bear market. That’s some 150 points of wiggle room for potential pump-and-dump perpetrators.

• Imagine the short-covering that would go on as the S&P soared.
• Imagine the capitulation from individual traders looking to re-enter long positions.
• Imagine the re-allocation into mutual funds as passive retirement savers took notice.

Then imagine the smiles on the faces of those who pumped up the stock prices artificially only to dump them on unsuspecting individuals.

It cannot be proven beyond a reasonable doubt; but now would be a perfect time for such a pump and dump scheme. The recent 7-year Bull market is still fresh enough in traders’ minds to make the scheme possible. The buy-the-dip mentality is not gone completely. Folks want to return to those bullish times – and maybe they will – but those same traders must be very careful now.

Cautious optimism is the key to avoiding what may now (and in the next several weeks) be an enormous pump-and-dump. Of all the Options Market Stages, Bear Market Stages 5 & 7 are notorious for classic pump-and-dump events; the current Stage 7 environment is ripe for one.

* 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 [email protected]

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Historical Bear-Market Option Performance

Thursday Evening Options Brief 11-Feb-2016