Did Delta Hedging Cause the Market's Latest Swoon?

Heavy put open interest on SPY may have contributed to steady selling pressure for stocks

by 5/19/2012 10:59:23 AM
Stocks quoted in this article:

If there was a silver lining to last week's miserable market action, it would probably be the respectable gain of 0.6% that Facebook (FB) eked out on its first day as a publicly traded company. But for those of us who aren't named Mark Zuckerberg or Eduardo Saverin, that definitely qualifies as cold comfort. Now that the major equity indexes have violated significant support levels, Todd Salamone warns that the technical forecast has grown cloudy. Worries still remain over the embattled euro zone, but -- now that a potential options-related headwind is behind us -- Todd highlights the key chart levels to watch this week for the Russell 2000 Index (RUT), S&P 500 Index (SPX), and PowerShares QQQ Trust (QQQ). Meanwhile, with various technical indicators breaking down (and inciting panic) all over the place, Rocky White runs the numbers to see whether traders can trust one popular sell signal. Finally, we wrap up with a preview of the notable earnings and economic events for the week ahead, as well as a few sectors of note.

Notes from the Trading Desk: The Key QQQ Level to Watch This Week
By Todd Salamone, Senior VP of Research

"Nothing in the stock market is guaranteed. But the sentiment and technical backdrops continue to favor the bulls, especially if we see improvement in the European headlines to act as a short-covering catalyst. In the absence of positive headlines, a range between last week's low and key overhead round-number areas on major benchmarks, as discussed in prior weeks, is possible during the next couple of months."
- Monday Morning Outlook, May 12, 2012

In March, we cautioned that the market could be in for a period of slowing momentum and choppiness, as major equity benchmarks simultaneously traded at key round-number resistance areas. After rejections at these levels -- and what appeared to be a mild pullback -- we began making bullish comments. The sentiment backdrop has been the kind that usually marks bottoms, major market indexes were trading around potential support levels, and we were seeing evidence that big fund players were taking interest in stocks on the pullback.

Last week, however, was a big disappointment from a technical perspective, as equities broke support and the market's benchmark volatility index advanced above resistance.

For example:

  1. The S&P 500 Index (SPX - 1,295.22) not only fell below potential support at the 1,340 level -- an area that acted as resistance on multiple occasions last year -- but it also fell below 1,333 (double the March 2009 low) and the round-number 1,300 area.

  2. The Russell 2000 Index (RUT - 747.21) fell below the 780 area -- the site of its 80-week moving average, which has acted as support and resistance on multiple occasions going back to 2004.

  3. The CBOE Market Volatility Index (VIX - 25.10) advanced above the 21 area, which is 50% above the March low and had capped VIX rallies in April and May. As I said in a previous edition of Monday Morning Outlook, a climb above 21 would put the bulls at risk for a move into the 27.50-28 region, which is double the March low.

So what, exactly, created what has been described as "orderly selling" in the equities market last week? Is it the negative headlines pouring out of Europe, with 16 Spanish banks downgraded by a major credit-ratings agency and political uncertainty still the flavor of the day?

Or is the current weakness due to the unwinding of a bullish position that JPMorgan Chase (JPM) took in the credit markets, which resulted in a huge trading loss for the company? I found it interesting that even as the Greece and Spanish markets finished higher on Friday (Greece to the tune of more than 3%), the U.S. market still managed to close lower, which is potentially indicative of domestic concerns.

Or was last week's price action driven in part by a delta-hedging decline related to the huge build-up of put open interest on major equity indexes and exchange-traded funds (ETFs)? As popular put strikes were violated one after another during expiration week, sellers of the puts may have been forced to short futures to keep a neutral position, creating a steady but sure stream of selling. The heavy put open interest strikes essentially act like "magnets," as one strike after another is taken out. Delta-hedging risk certainly grows during expiration week if the market gets off to a weak start, as it did last Monday, and there is heavy put open interest just below current prices. Check out the May put open interest (red) and call open interest (green) on the graph below heading into expiration Friday last week. If indeed the puts acted as magnets after the key 140 area was breached earlier in the week, it would explain the steady bleed down to the 130 strike.

If last week's sell-off can be partly attributed to delta hedging -- which is a high probability -- the market could right itself fairly quickly, as the short trades put on during expiration last week are covered, and mean reversion sets in after heavy selling in 11 of the past 13 days. But if this has everything to do with Europe and/or JPM, a negative tone could continue to beset the market for the next few months, in the absence of a positive catalyst.


SPY - May Open Interest Configuration


30-Minute Intraday Chart of SPY May 14-18, 2012

The sentiment backdrop continues to favor the bulls, but admittedly, the technical backdrop is questionable at this point. That said, the SPX comes into this week trading at yet another potential support level, as it sits on the late-October 2011 high, which coincides with a 38.2% Fibonacci retracement of the October low and April peak. If this level doesn't hold on Monday morning, look for a move down to the 1,257 area, which is both this year's and last year's breakeven point. In 2011, the SPX held its breakeven point at the March and June troughs.


Daily Chart of SPX since April 2011

Moreover, the RUT comes into the week trading 7 points above its year-to-date breakeven level at 740.92, which is potential support. But a move into the red could set up a retest of 700, which is double the March 2009 low, a 61.8% retracement of the October low and March high, and the site of the RUT's 80-month moving average.

Finally, note the closing level of the PowerShares QQQ Trust (QQQ - 60.81). As you might remember, the QQQ struggled to overtake the 60 level throughout 2011, but finally moved above this level in the first month of 2012. The 60 level is key, as it is half the all-time high in 2000. Bulls would like to see the QQQ remain above 60, but a move below this area would put the bears back in the driver's seat.

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