More Signs of a Market Bottom

05/04/2009 1:00 pm EST

Focus: OPTIONS

Bernie Schaeffer

Chairman and CEO, Schaeffer's Investment Research

Bernie Schaeffer, editor of the Option Advisor, says the market’s relative strength is giving long-term positive signals, and he thinks it’s a good time for options traders.

Technicians generally accept the hypothesis that at some market lows, the degree of downward thrust into the bottom is so overwhelmingly powerful that the odds of these lows equating to “the bottom” are significantly enhanced.

The theory is that such a thrust is indicative of capitulation by a huge investor constituency who react out of despair by selling indiscriminately. This capitulation serves to eliminate much of the overhead resistance on rallies off the lows (as those longs who had been on the fence have now already sold), and clears the way for a recovery that far exceeds the normal expectations for a bear-market bounce.

I focused on two oversold indicators:

1. The ten-month historical volatility (HV) of the Standard & Poor’s 500 index.  We’ve reached climactic levels on the ten-month HV, which finished at 49% in March and is currently at around these same levels. Such extremely high levels of volatility over a multimonth period are indicative of capitulative selling.

2. The 14-month relative strength index (RSI) for the S&P . The RSI is an indicator developed by the great technician J. Welles Wilder as a measure of the degree to which markets are overbought or oversold. The scale is 0 to 100, with high readings indicative of overbought conditions and low readings of oversold conditions.

The market was pretty impressively oversold [recently], with a 14-month RSI reading of about 25, which compared with an RSI low of 43 in November 1987 and 27 in September 2002. The actual RSI bottom occurred in February, which checked in with an “off the charts” low reading of 18.

Now here’s where it gets exciting. The 14-month RSI for the S&P currently stands at 31.15, and according to a recent study by Schaeffer’s Investment Research analyst Rocky White, “(the 14-month RSI) has reconquered the 30 level for the first time since September 2008. In the past, the RSI crossing above 30 on a monthly chart has signaled very good long-term buying opportunities.

“It is not common for this indicator to flash a buy signal—in fact, the most recent occurrence was in 1974, and the time before that was in 1942. There have been eight signals since 1900, [with] an average six-month return of 7.25% and an average one-year return of 22.8%. Also, seven of the eight one-year returns were positive.”

I see the current environment as particularly fertile for option buyers. The VIX, while still high historically, is down sharply from its peak levels in last year’s fourth quarter, and this means the price you “pay to play” in the options world has become much more reasonable.

Better yet, the movement potential for this market remains very robust, in part because the premium selling trade (which tends to compress stock price movement) was obliterated in the bear market and in part because both the bulls and the bears have strongly held views that they are willing to back up with real money.

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