Monday Morning Outlook

Dissecting Short-Term Risks to the Long-Term Bullish Case

What Black Friday means for the S&P 500 Index

by 11/24/2012 9:08:23 AM
Stocks quoted in this article:

The shortened week was long on gains, as the major indices all appreciated more than 3% for the week by Friday's early close. While the majority of investors were focused on the holiday circulars Friday, Todd Salamone was taking a hard look at CBOE Market Volatility Index (VIX) options trends to uncover any potential "short-term challenges" for the bulls. As for Black Friday, does it have any effect on the retail sector or the broader market overall? The answer is a resounding yes, and Rocky White has all the details.

  • Why VIX options expiration can impact the broader market
  • The S&P 500 Index has retaken 1,400, but is still south of these significant levels
  • What Black Friday means for stocks

Finally, we wrap up with a preview of the major economic and earnings events for the week ahead, plus a featured sector to watch.

Notes from the Trading Desk: Why the VIX Could Pressure Equities in the Short Term
By Todd Salamone, Senior V.P. of Research

"Absent any major negative news this weekend, we would not be surprised to see a Monday morning pop, as the S&P 500 Index (SPX - 1,359.88) is oversold and, if indeed some of last week's selling can be attributed to a delta-hedge decline, the dearth of this delta-hedge selling can be further supportive ... We see other similarities that might suggest a Monday pop is on the horizon. For example, at the end of May expiration week, the SPX came into the new trading week sitting on the late-October 2011 peak at 1,280 ... This week, the SPX finds itself sitting in the area of various 2011 calendar-year highs ... As a "for what it's worth," the 1,347 low on Friday marks a 61.8-percent Fibonacci retracement of this year's June low and September high."
-Monday Morning Outlook, November 17, 2012

"$SPX options strike me as very cheap at the moment - ATM Dec. 22 calls priced below SPX historical vol (HV), and puts in line with HV"
-@ToddSalamone on Twitter, Wednesday, November 21, 2012

"With expiration of November $VIX options today, $VIX option volume high - 470k calls and 249k puts - both around double expected"
-@ToddSalamone on Twitter, Wednesday, November 21, 2012

After an S&P 500 Index (SPX - 1,409.15) decline that was driven in part by delta hedging during the November 12-16 expiration week, the SPX indeed popped from support on Monday, as we anticipated. The advance was impressive, but the same issues remain with respect to fiscal cliff uncertainty, Europe -- most notably Greece, in the headlines once again -- and a mid-December European Union Summit.

The implication of this headline uncertainty is that fund managers could either remain on the sidelines until there is more clarity, or replace portfolio hedges, especially after the expiration of CBOE Market Volatility Index (VIX - 15.14) options this past Wednesday. VIX call options, for example, are used as speculative bets against the market or as a hedging tool for equity portfolios.

The table below, courtesy of our friends at Trade-Alert, shows VIX open interest by expiration month immediately before Nov. 21 expiration. As you can see, nearly 2.3 million November VIX calls just expired, representing 37% of all outstanding VIX call contracts. So, it was of no surprise to see huge VIX option volume on Friday, as market participants looked to replace VIX options that had expired. Given the call bias in the VIX options pit, a post-expiration build in VIX call open interest would not be surprising. This could also be a headwind for the market, as sellers of VIX calls may short equity futures to hedge some of their risk.

VIX Open Interest Report

One trend that stands out to us is the tendency for the VIX to advance immediately after the monthly expiration-related collapse in VIX call open interest. In the graph below (again courtesy of Trade-Alert), note that VIX "pops" have occurred after expiration-related call open interest "drops" during the past several months. The call open interest is green, while the VIX is the blue line.

VIX daily call and put open interest

How has the SPX behaved in recent months in the weeks immediately following VIX expiration? Per the table below, the first couple of weeks after VIX expiration have been a struggle, so this is certainly a short-term risk to the equity markets.

SPX Returns following VIX Expiration

Turning to the charts, while the SPX turned in an impressive performance in last week's holiday-shortened trading, there is still work that needs to be done. For example, technicians will have their eyes set on the 1,420 area, which acted as resistance for the first nine months of this year. The 80-day moving average, which acted as short-term resistance in mid-June and as short-term support in late-October/early November is coincidentally situated in this region. Also worth mentioning -- with the SPX closing at 1,409 on Friday -- is that the 50% retracement of the September high and this month's low is parked at 1,410.

Daily chart of the SPX since January 2012

We remain bullish on the market, despite the short-term challenges that could arise after Wednesday's VIX expiration. Bullish drivers include a strong rally this week off last year's resistance levels, following expiration-related selling the prior week. Meanwhile, short-interest levels remain relatively high amid evidence that the market movers (namely hedge funds) are underweight and under-producing relative to the SPX, with the clock quickly ticking down toward the end of 2012.

Will the hedge fund players seek risk in the waning days of 2012 and push equities higher? This certainly remains a possibility worth playing. Meanwhile, if you want to hedge your long exposure through Dec. 22 expiration, portfolio insurance remains cheap. For example, SPX (at-the-money) 1,410-strike put options are trading at 14.3% implied volatility, which is very reasonable given that 20-day SPX historical volatility stands at 15.5%.

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