Monday Morning Outlook

January Expiration Could Bring Bulls a Buying Opportunity

ISE sentiment data suggests there are still plenty of buyers on the sidelines

by 1/12/2013 9:42:17 AM
Stocks quoted in this article:

Stocks clawed their way to a positive finish last week, as investors erred on the side of cautious optimism ahead of the coming onslaught of fourth-quarter earnings. It could be the calm before the storm; the third week of 2013 promises plenty of excitement, thanks to a barrage of quarterly reports from big banks and the expiration of January options. After breaking down the last 10 years' worth of data on January expiration weeks, Todd Salamone has some advice to offer the bulls.

  • How to interpret last week's spike in VIX call volume
  • Find out the SPY support and resistance levels to watch this week
  • What ISE option data is telling us about investor sentiment

Finally, we close 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: Are Stocks Due for a Pullback this Expiration Week?
By Todd Salamone, Senior V.P. of Research

"With the SPX trading at a former peak, and portfolio insurance low -- relative to both historical volatility and its range during the past couple of years -- a creep higher in volatility would not be a major shock. Should volatility increase, as measured by the VIX move higher, we wouldn't be surprised if this occurs amid a period of choppiness ... But with the S&P 400 MidCap (MID - 1,056.07) trading at all-time highs, in an apparent breakout above the brick wall at 1,000, this is the kind of leadership that bulls welcome, as the strongest market periods are coincidental with small-cap and mid-cap leadership. Combine this with the big relative short position in the market, amid another round of calls for higher volatility as we enter the new year, it appears the long volatility trade could be destined to be a loser in 2013 like it was in 2012."
-Monday Morning Outlook, January 5, 2013

"$VIX call volume running high again at 1.5x's normal, with focus on March options. Put volume extremely light, lowest this year"
-@toddsalamone on Twitter, January 10, 2013

"CBOE VIX Call volume 3x normal this morning, led by a massive buy of 70000 March 25-35 call spreads for 59cents a moment ago. Floor notes buyer is looking for more offers, and this flow continues a trend that appears to show portfolio managers taking advantage of the multi-year lows in VIX by loading up on upside calls."
-Henry Schwartz, Trade Alert, January 11, 2013

Even though the CBOE Market Volatility Index (VIX - 13.36) made a new multi-year low last week, and the S&P 500 Index (SPX - 1,472.05) pushed up to just a couple of points below its September high, not a lot changed from the first Friday close of 2013 to the second. All said, the SPX drifted a few points higher, and the VIX changed by only about half of one basis point.

But one clearly noticeable factor was the reaction to the new multi-year lows in the VIX. Call open interest on the "fear index" surged last week on heavy volume, with the February and March series leading the way. The chart below, courtesy of our friends at Trade Alert, illustrates how VIX call players made a resurgence after smartly avoiding calls when the VIX surged in late December, and are now adding calls (smartly?) as the VIX hits new multi-year lows.

I put that question mark behind "smartly" because it makes sense to be a call buyer on VIX declines -- but then again, this call buying wasn't exactly smart in 2012, as traders continuously hedged against or speculated on a severe market pullback via the purchase of far out-of-the-money VIX call options. For example, as Michael Santoli wrote in his Yahoo! Finance column, "Is the Market's Rush to Relax a Reason to Stress?":

"... Bernie Schaeffer of Schaeffer's Investment Research and Henry Schwartz of Trade Alert looked at all call options on VIX futures (which profit from higher VIX levels) traded in 2012 and determined that more than 95% of them expired as worthless."

This research supports what we have said over the past few weeks -- namely, that VIX pops tend to occur when total call open interest is at a relative low point. This holds particularly true right after VIX expiration, which occurs this Wednesday, two days before the expiration of equity, index and exchange-traded fund (ETF) options.

 VIX Daily Open Interest

Per the first table below, during the past 10 years, January expiration week hasn't been kind to the bulls, with only two of those weeks trading higher. Out of curiosity, we looked at expiration-week returns based on what the market had done month-to-date (MTD) heading into January expiration, breaking up the results by negative returns, a rally of less than 2%, and a rally of more than 2%.

As you can see in the second table below, we found that negative MTD returns in January led to the weakest expiration weeks, while strong market returns -- like we have experienced in 2013 -- preceded modest pullbacks. In fact, in five out of the last 10 years, the SPX boasted a return of 2% or better through the first two Fridays of the month .

 January Expiration Week Returns since 2003

Monthly Chart of VIX since January 1993

As for levels to focus on this week, we refer to the open interest configuration of the SPDR S&P 500 ETF Trust (SPY - 147.07). There is huge call open interest at the 148 strike on this ETF, which also happens to be the site of the mid-September 2012 high. Given these calls were purchased, this strike could act as a magnet if the market defies historical tendencies next week and advances.

If the SPY pulls back, look for support in the 145 zone. This is the site of heavy call and put open interest, as well as the May 2008 calendar-year high that preceded the sharp downturn into March 2009.

 January SPY Open Interest Configuration

 Daily Chart of SPY since August 2012

Thought short-term pullbacks remain a possibility, we remain bullish, and such pullbacks should be viewed as buying opportunities. Small-caps and mid-caps continue to outperform, even as a huge short position remains and the "tail-risk protection" trade remains the strategy du jour. Such caution within the scope of strong price action bodes well for the bulls.

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