As Critical Levels Are Tested, Here's a 'Glimmer of Hope'

The historical significance of the market return heading into the Easter holiday

by 4/12/2014 8:15:42 AM
Stocks quoted in this article:

Stocks mounted a high-volume, broadly based pullback during the past week, led by technology stocks and momentum names. With geopolitical concerns largely relegated to the back burner and domestic economic data staying relatively upbeat, there were varied theories as to what prompted this sell-off, including one related to Tax Day. By the time Friday's closing bell put an end to the selling, some of the major indexes had breached technical support, while others had dipped back into negative territory for 2014. As we enter a shortened trading week that includes the expiration of CBOE Volatility Index (VIX) futures options on Wednesday, Todd Salamone lays out a number of factors for all market participants to keep on their radar.

  • Round numbers: then and now
  • A delta-hedging refresher as expiration approaches
  • Why Rocky White is eyeing the market's year-to-date return ahead of Easter

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: Two ETFs to Monitor Into Expiration Thursday
By Todd Salamone, Senior VP of Research

"Depending on the week, at least one of several equity benchmarks that we track has been influenced by year-to-date breakeven levels acting as support or resistance. Or, a round-number century or millennium mark will come into play... "
-Monday Morning Outlook, April 5, 2014

"The need for investors to raise cash in 2014 to pay substantial capital gains, or taxable income from the sale of investments held longer than a year, has added to selling pressure ahead of the April 15 deadline to file tax returns, market watchers say."
-The Wall Street Journal, April 9, 2014

"Short positions in the VIX have been 'completely abandoned,' strategists led by Alain Bokobza wrote. 'Somewhat lower levels of volatility recently, combined with a risk of a spike in volatility due to geopolitical tensions with Russia, are likely to have an influence, but alone not explain the trend,' they wrote. 'Hence our conclusion that the period of low volatility is coming to an end.'"
-Bloomberg, April 11, 2014 (referencing a note from Societe Generale SA strategists)

It was just last week that we were discussing the importance of round-number levels overhead on key equity benchmarks such as the S&P MidCap 400 Index (MID - 1,318.50), S&P 500 Index (SPX - 1,815.69), and Russell 2000 Index (RUT - 1,111.44), at 1,400, 1,900, and 1,200, respectively. Just one week later, as the MID and SPX retreated below their respective year-to-date (YTD) breakeven marks, and the RUT was rejected at its YTD breakeven mark (last week's high was 1,160, with YTD breakeven at 1,163), bulls are looking for round numbers to come into play, this time as support.

The most notable benchmarks testing potential round-number support are the Nasdaq Composite (COMP - 3,999.73) and Dow Jones Industrial Average (DJI - 16,026.75), which are perched near their respective millennium levels at 4,000 and 16,000. In fact, bulls are hoping the 4,000 level can mark support once again for the COMP, as it did in late 2013 and at the early February bottom. One key difference between early February and the present is that the COMP was trading in the vicinity of its 80-day moving average in February -- a trendline that had supported pullbacks in April, June, and October 2013. This time, it was the 80-day moving average that marked last week's peak, which adds risk to 4,000 holding.

Horizontal line represents 4,000 millennium mark
COMP since March 2013 with 80-day moving average

As we mentioned above, potential support from round-number levels could come into play for other benchmarks this week, such as the MID (at 1,300), RUT (at 1,100) and SPX (at 1,800). With respect to the RUT, the 200-day moving average sits at 1,105, just above the 1,100 century mark. Meanwhile, the MID comes into the week sitting on its 140-day moving average, a trendline that is not used by many market technicians, but has marked support on three occasions since June 2013.

Horizontal lines mark round numbers at 1,300 and 1,400
MID daily chart since March 2013 with 140-day moving average

In addition to the April 15 tax deadline that comes this week and -- according to some -- has been an impetus for the sell-off in last year's winners, keep in mind that we move into a holiday-shortened expiration week, with CBOE Volatility Index (VIX - 17.03) futures options expiring Wednesday and the market closed on Friday.

With April expiration week imminent, let's look at the open interest configuration on key equity exchange-traded funds (ETFs), such as the iShares Russell 2000 ETF (IWM - 110.41), which is about one-tenth the value of the RUT, and the SPDR S&P 500 ETF Trust (SPY - 181.51), which is approximately one-tenth the SPX's value.

Encouraging for bulls is that it is possible that some of this sell-off could be attributed to delta hedging, which is likely to end if stocks can stabilize slightly below or above the 180 level on the SPY and 110 level on the IWM.

Delta hedging occurs when sellers of outstanding put contracts hedge by shorting more and more equity futures as heavy put strikes on indexes and ETFs come into play and are penetrated to the downside. The more sensitive these options become to a continued decline in the market (sensitivity of which is derived from the underlying ETF or index's proximity to the strike), the more likely shorting activity will occur. Therefore, the heavier the put open interest at a particular strike, the higher the magnitude of the potential selling occurs.

If there is any glimmer of hope for the bulls, it is that most of the heavy put strikes on SPY and IWM April options have been penetrated, with the largest put strikes at the 110 level on the IWM and 180 level on the SPY. At strikes below these levels, put open interest is not nearly as heavy, and thus becomes less of a factor.

Bulls would really like to see the market stabilize quickly, and if we are able to move through expiration week without the 110 and 180 strikes being tested, any short positions related to put open interest at these strikes will be unwound, which could be supportive of the market. That said, if equities continue their downward trajectory, delta hedging could generate a temporary move below these put-heavy strikes, meaning round-number century marks, such as SPX 1,800 and RUT 1,100 would be violated.

IWM April Open Interest Configuration

SPY April Open Interest Configuration

Continuing with the expiration week theme, VIX futures options expire on Wednesday, with the peak call strike at 18. Coincidentally, this is 50% above the VIX January low, and as we have mentioned before, multiple VIX peaks have occurred at an area 50% above its YTD low or a recent low. The risk for bulls, however, is a surge in volatility (as measured by April VIX futures), through the 18 area and straight to 20, where there is also significant call open interest that could act as a delta-hedging magnet. (That is, sellers of VIX calls may short equity futures if short VIX call positions become more and more sensitive to advances in April VIX futures.)

Will sellers of volatility resurface after the latest VIX pop?
VIX Daily Chart since December 2013

Finally, short interest for the end of March was reported this past week. Short interest on SPX component names continues to rise, and is at the highest levels since 2012. However, with major equity benchmarks in negative territory this year, the shorts could grow bolder in the weeks ahead. As such, growing short interest could become a headwind, which is opposite the potential implications of high short interest in an advancing market, when the shorts are in less control. As of now, they are in the drivers seat, which is a risk to bulls, unless and until benchmarks can make a serious run into positive territory for 2014.

S&P 500 Index and total short interest since January 2011

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