U.S. equities markets started -- and ended -- the week on a strong note, thanks to a round of better-than-expected earnings from both the banking and tech sectors. Additionally, despite a mid-week retreat due to cautious Fed statements and geopolitical developments, both the Dow Jones Industrial Average (DJI) and broader S&P 500 Index (SPX) found support atop the millennial 17,000 mark and the half-century 1,950 level, respectively. Coming off of July options expiration week, though, Todd Salamone explains why we could continue to see range-bound action in the near term, and why "volatility should drift lower."
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: How VIX Options Expiration Affected This Week's Market Movement
By Todd Salamone, Senior VP of Research
"As we move through the dog days of summer, we think the market is at an increased risk of sideways movement, much like we saw in March through May. Right now, it is being dogged by overhead round-number millennium and century-mark levels ... Therefore, we see the potential for another range to develop -- bound by 1,940-1,950 on the downside, and 1,980-2,000 on the upside."
"... expiration is next week. Big put open interest resides at the 110 through 115 strikes on the iShares Russell 2000 ETF (IWM - 115.10). The risk to bulls is that these put strikes could act like magnets if the IWM makes a major move below 115 during expiration week, as sellers of those puts must short the IWM to remain neutral when each strike comes into play -- a process called delta-hedge selling. Delta-hedge selling -- which occurs rarely, but is a possibility one must be open to -- could push the IWM (and RUT) below support in the 115-116 area (1,150-1,160 on the RUT), to the May lows in the 110 area (or 1,100 on the RUT) ... Unlike what seems to be a growing chorus expecting a correction, we don't see major downside from here. But then again, we think the upside could be limited, too, in the immediate weeks ahead."
-Monday Morning Outlook, June 12, 2014
"$VIX put volume twice normal, p/c volume ratio the highest since 4/1's 1.30 reading, which preceded weakness in $SPX"
-@ToddSalamone on Twitter, July 14, 2014
"Delta-hedge, expiration week selling in $IWM - discussed the possibility of this last weekend"
"$VIX call volume brisk a day after July options expire. Headlines creating rush into 'replacement' calls, creating additional headwind?"
"Last time $IWM broke 200-dayMA was during May expiration week - July expiration week a repeat episode"
"$VIX high was 15.38 yesterday. 50% above most recent low of 10.28 is 15.42. Many $VIX peaks have occurred 50% above previous low."
-@ToddSalamone on Twitter, July 17 and 18, 2014
"Valuation metrics in some sectors do appear substantially stretched -- particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year."
- Fed Chair Janet Yellen in a written report, via CNBC, July 15, 2014
Last week, we advised being open to the possibility of small-cap stocks -- as measured by the iShares Russell 2000 ETF (IWM - 114.23) -- experiencing a delta-hedge decline if the 115 strike was breached to the downside. We made this comment due to the heavy put open interest at one-strike intervals from 115 down to the 110 strike. It took a few bearish headlines -- the "kindling wood" to get the fire started -- to set into motion what we think was selling exacerbated by another delta-hedge sell-off during expiration week (the last time this occurred was May expiration week).
On Tuesday, it was written comments by Federal Reserve Chair Janet Yellen referring to stretched valuations in the small-cap group, specifically biotech and social media stocks. The sell-off was muted relative to Thursday, as July call options on the CBOE Volatility Index (VIX - 12.06) -- typically purchased for portfolio protection -- had not yet expired, reducing the odds of panic selling or the need for an un-hedged player to put a hedge in place in reaction to this news. On Thursday, just one day after VIX July options expiration, headlines about the U.S. levying more sanctions on Russia, reports of a Malaysian airliner being shot down over Ukraine, and reports of Israel's ground assault in Gaza hit the wires.
Thursday's sell-off was likely magnified by expiration. First, since some market participants were vulnerable due to portfolio protection via VIX calls expiring the previous day, there was a mad scramble to "re-up" for another month of portfolio protection, driving short-term volatility higher (more on this later). Strong demand for VIX calls is commonly a coincidental headwind, as sellers of the portfolio protection (VIX calls) will typically short equity futures to hedge.
Plus, there was still heavy put open interest below the market on equity index and exchange-traded options that had not yet expired. These puts grew more and more sensitive to the declines in the broader market as the underlying approached the respective strikes. Therefore, sellers of those puts had to short more and more equity futures to maintain a neutral position, putting more downward pressure on stocks.
The overnight alleviated this effect, as once a little bit of buying entered the market Friday morning, the "reverse mechanics" were in play, as short covering emerged related to expiring out-of-the-money puts, generating a mirror image of the day prior -- and net sideways action on a close-to-close basis.
There are a couple of observations that we have related to volatility. First, the VIX high on Thursday reached 15.38, just shy of the 15.42-15.48 area that is 50% above the July 3 intraday and closing lows. As we have mentioned numerous times, there has been a tendency the past couple of years for the VIX to peak 50% above a recent low. Therefore, it is entirely possible that a VIX peak is in place for the short term.
Secondly, the relatively new CBOE Short-Term Volatility Index (VXST - 12.05) -- a measure of expectations of 9-day volatility -- jumped far above expected 30-day volatility, as measured by the VIX. In fact, per the chart below, which is the VIX relative to the VXST, the ratio hit an extreme low. Such lows usually mark climactic short-term fear in the market, setting the market up for a short-term rally.
As we have anticipated, by the end of the week, it was a sideways (but volatile) market, driven in part by expiration mechanics as we alluded to above, and also by round numbers, as we discussed last week. For example, the NYSE Composite (NYA - 10,985.92) and Wilshire 5000 Index (W5000 - 20,912.56) continue to struggle with millennium levels overhead at 11,000 and 21,000, respectively. Not to be forgotten is the Dow Jones Industrial Average (DJI - 17,100.18), which closed back below 17,000 on Thursday, after first closing above this level on July 3. In fact, the two-week "sell signal" discussed on July 4, associated with the DJI's first-ever touch of the 17,000 level, closed on Thursday. The actual decline was 0.53% from the July 3 close of 17,068, compared to an expected decline of 0.36%. In five of the past eight instances that the DJI crossed a new millennium mark for the first time ever (10k-17k), the DJI has been lower two weeks later.
That said, by week's end, the Nasdaq Composite (COMP - 4,432.15) held the 4,400-century mark, the S&P MidCap 400 Index (MID - 1,412.73) held at the round 1,400 century mark, while S&P 500 Index (SPX - 1,978.22) futures held Thursday's overnight lows in the 1,940-1,950 area, the half-century mark that we speculated would be revisited multiple times during this anticipated trading range and act as potential support. As we have said numerous times, half-century marks on the SPX have historically had significance as both support and resistance, like 1,950 currently, and the 40-day moving average, which resides just below the 1,950 area.
Our outlook hasn't changed: we expect sideways action as we move through the summer, with the SPX bound by formidable resistance in the 1,980-2000 area, and support in the 1,940-1,950 zone. Meanwhile, volatility should drift lower. The fact that so many have hedged against rising volatility should, in fact, keep volatility low for the foreseeable future. In fact, 10 calls were opened on the VIX for every one put in Thursday's trading, an unusually high ratio. And this occurred after an abnormally low ratio on Monday (see Tweet in excerpts above), when VIX puts were extremely active, just ahead of this week's VIX pop.
Finally, the IWM's break of its 200-day moving average and year-to-date (YTD) breakeven level at 115.36, driven in part by the mechanics of expiration-week selling, could present another buying opportunity just like that of May, when the 200-day moving average proved to be a bear trap.
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