Stocks took a turn for the worse last week, with many major equity indexes now sitting on year-to-date losses. At the same time, the CBOE Volatility Index (VIX) vaulted to its highest level since last October. With some closely watched support levels breached amid the sell-off, Todd Salamone warns that a widely expected market correction could actually become a self-fulfilling prophecy in the weeks ahead -- and explains how bulls might prepare for a continued slide.
Finally, we close with a preview of the major economic and earnings events for the week ahead, plus our featured sector.
Notes from the Trading Desk: Expected Correction Could Become a Self-Fulfilling Prophecy
By Todd Salamone, Senior VP of Research
"VIX pops (market selloffs) have generally occurred after VIX expiration, although only 32% of VIX call open interest is in the January series, down from the usual 40-50% in the front-month series. The implication is that VIX call open interest, used as portfolio protection, should remain relatively high following this particular VIX expiration."
-Monday Morning Outlook, Jan. 18, 2014
"$VIX at 14+ has retraced 50% of its recent high and low; a 50% retracement marked a $VIX top in mid-December (also around $VIX expiration)"
"$VIX 330k call adds against only 92k put adds overnight; 6.6 million outstanding call contracts, which is a huge number post VIX expiry"
"$MID and $RUT trading right on or above respective 50-day moving averages as $SPX break below its 50-day moving average garners attention"
"Over 1.12 million $VIX call options traded today, 52-wk high is 1.14 million on 10/8/13, which marked a major bottom"
-@ToddSalamone on Twitter, Jan. 23 and 24, 2014
"Dow and S&P Slip Below 50-Day Moving Averages"
-CNBC TV headline, Jan. 24, 2014
With China's economy not living up to expectations and emerging market currencies (such as the Turkish lira, Argentine peso, South African rand, Russian ruble, and Indian rupee) declining sharply, U.S. equities sold off last week. In fact, the S&P 500 Index (SPX - 1,790.29) broke below its 40-day moving average, thus erasing the potential repeat pattern of 2013's first quarter that we anticipated, when this trendline contained multiple pullbacks during an impressive first-quarter rally. In fact, Friday's sell-off pushed the S&P 400 MidCap Index (MID - 1,314.07), Russell 2000 Index (RUT - 1,144.13) and Nasdaq Composite (COMP - 4,128.17) into the red for 2014.
Coinciding with last week's sell-off, the CBOE Market Volatility Index (VIX - 18.14) surged. The VIX pop -- which occurred after 2.5 million call contracts on VIX futures expired on Wednesday -- broke a recent pattern. In two of the last three such spikes, a 50% retracement of the most recent high and low marked a peak (see chart below). But as we have observed in the past, multiple VIX peaks during the past couple of years have occurred at either 50% above or double a recent low. We enter next week with the VIX already situated in the area that is 50% above the low -- and in the absence of an immediate move lower, a move to double its low, in the 24 zone, might complement the "much anticipated" 5%-10% percent correction. Currently, the SPX resides 3.5% below its mid-January closing high.
As we mentioned above, many stock market participants are bracing for a correction, as is evidenced by the huge call open interest on VIX options. In fact, even though January VIX options expired last week, there are still 6.6 million outstanding call contracts -- a record this early in the VIX expiration cycle.
Since the VIX tends to sharply advance during corrections, speculators and hedgers will buy VIX call options to profit from or insulate a long portfolio against the ill effects of a sharp pullback. Most of the time, such fear is misplaced, and when these trades are unwound, the market advances.
On rare occasions, however, such fear becomes a short-term risk, particularly when sellers of the portfolio protection trades (VIX calls and equity index puts) are not fully hedged. At present, more than 50% of open VIX call contracts are in the February option series, which expire Feb. 19, 2014 -- which means many are expecting, or hedging against, a correction between now and then. Moreover, many of these options were purchased far out of the money, implying they had little sensitivity to VIX movements when originally purchased.
The implications are that sellers of these calls do little hedging (for example, selling S&P futures) when the trades are initiated, since the call options they sold to those seeking portfolio protection are not very sensitive to day-to-day VIX moves. However, when the VIX begins to rise sharply to call-heavy strikes, those who sold the call options become increasingly exposed, and might offset their risk by shorting more and more S&P futures. Therefore, in rare instances, an expected correction might become a self-fulfilling prophecy -- a short-term risk we are faced with presently.
In other words, if the market doesn't right itself relatively quickly, further advances in the VIX could create a "snowball" effect in which selling of S&P futures increases as these heavy VIX call open interest strikes come into play (a concept known as "delta hedging"). Remember, VIX options are based on VIX futures, as opposed to the more publicized VIX cash. You can find VIX futures quotes at Barchart.com.
Currently, February VIX futures are trading at 15.70, just under the call-heavy 16 strike. This strike and many others (as seen on the chart below) could act like magnets in the near future, as hedging via shorting S&P futures creates higher volatility, which creates more S&P futures selling ... and the pattern feeds on itself until sellers of the calls are nearly or fully hedged.
The risk in the market is not necessarily the SPX's break of its 50-day moving average, which received considerable attention on Friday. In fact, moves below the 50-day trendline in 2013 simply shook out the weaker hands and proved to be outstanding buying opportunities -- which is another possibility that cannot be ruled out, given the large outstanding short position and the possibility that shorts use this weakness to cover.
The risk we see is the enormous out-of-the-money VIX call open interest in the February series, which may induce increased selling of S&P futures if February VIX futures move near or above the heavy call open interest strikes noted in the graph above. One way to protect against this growing possibility -- a market that continues to fall amid rising volatility -- is to buy VIX call options as a hedge. There is now an increasing probability of a sharp move to the 24 area, or even 28-30, ahead of the expiration of these options in February.
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