By Chris Ebert
Measuring how hot or cool the S&P 500 stock index is can be done by studying some commonly traded stock options known as Covered Calls. Covered Calls almost always return a profit outside of a Bear market, so conversely, if expiring broad-based $SPY Covered Calls are returning a loss, the market as a whole has likely switched to a Bear.
While there are millions of possible options, the ones used to determine the S&P 500 Temperature are specifically designed to be the most indicative of the state of the moderate-term outlook (4 months) for most stocks traded in the S&P index, opened at-the-money 4-months prior to the current week’s expiration.
”The level of the S&P can then be compared to the level at which Covered Calls would break even. The distance from the break-even point then determines the Temperature. Right now it is hotter than it has been in many years. The following chart shows the cyclical nature of how extremely hot Temperatures tend to lead to a cooling off period.
The S&P recently set a high Temperature record, as measured in the manner above. It can be important for a trader to take note, because such records are rare. Often they mark the top of a cycle, when stock prices stop rising and take some time to consolidate or pull back before they resume the next uptrend. Now may be one of those times.
Though the thermometer is not 100% accurate, it can give a trader something to keep in the back of the mind – S&P 500 Temperatures over 250 are rarely sustainable.
The current Temperature is clearly Lottery Fever, in which corporate fundamentals are irrelevant and technical traders are in control.
Another way to look at it is to view how the S&P has progressed through the Options Market Stages over the past year. It has clearly reached the limit of Lottery Fever. Though that limit is not written in stone, and it is possible for the S&P to exceed it, anything above the limit has tended to be unsustainable over the past 20 years or so. The distance above the red zone is used to calculate the Temperature shown above. The current Temperature of 252 suggests the uptrend is sustainable. It does not mean it will be sustained, just that in a purely technical sense there is no compelling reason for the trend to end.
There is no way to predict the future though, and fundamental changes or other catalysts could very well alter the trend. But for now, the options analysis says this trend is sustainable.
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
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