A subscriber brought something to my attention that I wish I had thought of before. We think (at least I did) that the SPY (ETF) and SPX (S&P 500 Index) perform pretty much the same except for some minor tracking error. However, this is not the case because the SPY historical data is adjusted for dividends, whereas the SPX is not.

For all practical purposes, the SPY is a stock, and when the SPY pays a divdend, its historical data must be adjusted so that it maintains the correct relationship with the current dividend adjusted price. This happens on all stock, ETF, and mutual fund data. (To learn more, click here.) While it may be technically possible, historical data for an index like the SPX is not adjusted for dividends, so the effect of dividends is not considered for indexes.

Let's take a look at what this means. On this SPX chart we can see two major tops, 2000 and 2007, challenging the same level of overhead resistance at about 1550. The top of the current bull market is still about 200 points below this resistance.

Now, looking at the SPY chart, which has been adjusted for dividends, we can see that the 2007 top exceeded the 2007 top by about 15%. And of more immediate interest, the current bull market top is virtually equal to the 2007 all-time high. This encounter with long-term resistance could spell immediate trouble for the bull market.

There is a new index, the S&P 500 Total Return Index ($SPXTR), that appears to accommodate dividends by using a positive adjustment to the current price, but there is not even a full year's data collected on it yet, so it is not likely to be a useful technial analysis tool during my lifetime. Besides the SPY already does the job and we have nearly 20 years of data on it.

Conclusion: The fact that indexes are not adjusted for dividends can cause them to present a different technical picture than their ETF counterparts. While many of our timing models are driven by indexes, one should always use the chart of the trading vehicle (ETF) to finalize a trading decision.

Once a month, the stock market provides us a unique opportunity.  In basketball terms, it's like the market makers have the ball with time running out in the quarter - or the game - and they nearly always bury that critical three-pointer.  For those more predisposed to hockey, think about the "empty net" goal to close out the game.  That's probably more fitting because the retail trader is mostly defenseless as the market puck sails into the net.

Options expire the third Friday of every month.  It's a day of reckoning for options traders.  When the option trader buys or sells contracts, think for a minute who's on the other side of the trade.  With the most fluidly traded options, it can be the retail trader on both sides of the trade.  But many stocks don't have the kind of contract volume on a daily basis that's necessary to match up retail buyers and sellers and you see "open interest" build. 

Enter the market maker.

Let's assume you buy 10 calls on ABC stock and the market maker sells you those calls.  To appropriately manage risk, that market maker can then turn around and buy 1000 shares (10 calls represent 1000 shares as each call gives the purchaser the option to buy 100 shares at some future point at a fixed strike price).  It's a familiar covered call strategy.  Therefore, if ABC continues rising, the market maker is protected as they own the stock.

But think about what happens if ABC moves higher for a period of time and builds a lot of net in-the-money call premium, then reverses suddenly (and, in many cases, temporarily).  The market maker owns 1000 shares, so they can potentially benefit from the gain leading up to options expiration Friday.  What if that market maker sells their long position, then begins to short ABC as options expiration Friday approaches?  They effectively close out their long position with a gain no doubt.  Then as ABC mysteriously falls, market makers make money again on their new short position.  As ABC falls during options expiration week, what happens to all of the net in-the-money call premium?  It vanishes as the market maker rings the cash register again.

It's an empty net goal.  Game over.

Every month, the week before options expiration, I calculate "max pain" for the SPY, QQQ and IWM.  I define max pain as the point at which in-the-money call premium EQUALS in-the-money put premium.  It's the market makers' version of the "perfect storm".  Once I calculate max pain, I do NOT look for the major indices to reach the level of max pain.  Instead, I simply use max pain as a directional indicator as I would the MACD.  It's a part of my overall strategy, not my entire strategy.  Last week, for instance, the SPY and QQQ showed a max pain level very close to its then current price.  The IWM, however, traded at $79.54 with a max pain level of $81.65.  Tuesday's high on the IWM was $81.55.  Check it out:

There was net in-the-money put interest, which suggested that IWM (small caps) would have a gravitational pull higher in the very near-term.  In order to benefit from this potential move, you could trade the IWM or find individual stock alternatives with a similarly skewed net option interest on the put side. 

Happy Trading!