The current market environment has a lot of bullish things going for it. Small-cap stocks have been outperforming, the market’s fear gauge — the S&P 500 Volatility Index — has rarely been this low and economic news has continued to be relatively stable. However, like they say in the movies, “It’s quiet out there … maybe a little too quiet.”
All kidding aside, there are two issues with a flat market that are big concerns for option traders.
First, the low level of volume means that breakouts are rare and tend to be preceded by whipsaws. For example, Best Buy Co Inc (NYSE:BBY) sold off last week only to reverse and spike higher on a surprise increase in same-store sales.
S&P 500 Stocks and Volatility
Whipsaws aren’t uncommon in any market, but the tendency for S&P 500 stocks to reverse their short-term trends on a news event like this is much more frequent than it would be otherwise.
This could present some interesting opportunities, but it also means that profitable trades should be cut short before an expected announcement. Breakout reversals like this were a very common “problem” in the summer of 2015 and in the fourth quarter of 2012 for the same reasons.
The second issue that traders deal with in an extremely flat market is a low level of correlation. Unfortunately, low-correlation markets have a much more unpredictable relationship with fundamental factors that would otherwise be expected to lead to a rally or a decline in price. Stocks are more likely to unexpectedly fall on good news and rise on bad news.
As you can see in the chart above, the implied correlation among the stocks of the S&P 500 dropped off a cliff after the Brexit in late June. To put it in perspective, if the index was at 100, stocks would be almost perfectly correlated, which tends to only happen during a market crash. A correlation index that is in the mid-40s is very low and means that stocks are trending relatively independently from their peers.
Correlations were in this low range right before the August 2015 correction, but it’s not a very good bearish indicator. On average, there is a small bias to the downside during those breakouts, so traders should be careful, but it’s not consistent enough to rely on for positioning. What low correlations, volume and price ranges do tell us is that the subsequent breakout tends to be very strong regardless of the direction it takes.
The volatility, volume and range compression are net negatives for option traders because they erode time value and disconnect stock prices from the underlying fundamentals (good and bad).
However, the positive within this situation is that the subsequent breakouts tend to be very strong and have lots of profit opportunities. Our plan is to maintain exposure to the market, so we can profit from the eventual breakout, but with more short-term exits before news events than we might otherwise be inclined to take.
InvestorPlace advisors John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.
