By Chris Ebert
It has been quite some time since the S&P 500 became so overextended that it could be considered to be under the effect of Lottery Fever, which is essentially runaway greed. When lottery jackpots become very high, all reason seems to go to the wayside and folks buy lottery tickets simply because the jackpot is large despite the low odds of actually winning.
The same phenomenon affects the stock market from time to time. When stock prices rise very quickly there is a sense among many traders that they don’t want to miss out on the rally. Those traders then buy stocks in order to get in on the action. Their buying in turn fuels the rally, which then attracts even more buyers in a vicious circle in what would best be described as a process of positive forcing. In other words, the process of buying forces more buying.
Lottery Fever in the stock market is not rare. It happens all the time. But detecting it can be a problem. It can be difficult for a trader to know whether stock prices are rising because of a fundamental change in the economy or whether prices are rising simply because the cycle of greed and fear has reached the greed stage once again.
One way of determining the presence of greed and Lottery Fever is through the Options Market Stages. Since certain option trades on the S&P 500 such as at-the-money Long Straddles are only profitable when the S&P 500 itself has gone outside of a zone that would be considered normal and expected by most traders, the profitability of Long Straddles can be used as an indicator of normality.
At the present time, expiring Long Straddles are profitable, indicating the S&P 500 is not in a normal state. It is overextended. That doesn’t mean it won’t continue to climb. Quite to the contrary, as with a lottery with a huge jackpot, the overextended stock market feeds on greed and can attract investors on the sidelines and grow even further extended, sometimes for weeks or months.
While nothing is ever certain about the stock market, one thing is: When Lottery Fever takes over, when S&P Long Straddles profit, corporate fundamentals have become less important to traders than participation in the rally in stock prices. It won’t last forever, but it’s great while it lasts!
The preceding is a post by Christopher Ebert, 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