Protecting Your Portfolio Amid 'Cliff' Uncertainty

How will the SPX fare during Thanksgiving week?

by 11/17/2012 11:15:49 AM
Stocks quoted in this article:

Stocks spent most of the week swimming in red ink, thanks to escalating uncertainty about the looming "fiscal cliff." However, signs of bipartisanship brought a few buyers from the sidelines on Friday, with congressional leaders calling initial negotiations "constructive." As Todd Salamone notes, purchasing options "insurance" might help the bulls sleep better at night, as will keeping a close watch on potential support for the S&P 500 Index (SPX). Meanwhile, Rocky White takes a walk down memory lane, and explains why the selloff thus far in November could have bearish implications this week.

  • Levels of potential support to watch on the major indexes
  • Why a Monday pop could be in the cards
  • A history lesson on Thanksgiving week returns

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: Levels to Watch This Holiday Week
By Todd Salamone, Senior V.P. of Research

"Last week's decline could have been exacerbated by a bearish 'call unwind, put delta hedge,' as the large put strikes act as magnets once momentum picks up to the downside. If Friday's stability holds through early next week, the opposite (bullish) mechanics could be in play -- a bullish put unwind that drives the market significantly higher. That said, should the market weaken, a visit to SPX 1,350 (or SPY 135), would not be surprising. Short-term traders should be prepared for both scenarios."
-Monday Morning Outlook, November 10, 2012

"$SPX don't be surprised if we pop Monday morning, given some of this week's selling was expiration-week/delta-hedge related"
-@ToddSalamone, Twitter, Friday, November 16, 2012

Last week, we discussed the November open interest configuration on the SPDR S&P 500 ETF Trust (SPY - 136.37), and left open the possibility that a move down to the 135 area could be in the cards, with the comment that short-term traders should be prepared for a bullish unwind or a continued delta-hedge decline, down to the 135 strike on the SPY. It turned out that the latter scenario played out, with Friday's low around the 135 strike -- host to the largest out-of-the-money put open interest in the November series going into last week's trading, one of several strikes that would act as a magnet during a delta-hedge decline, and the strike most likely to be defended. Combine this with the fact that the SPY 135 area represents a former area of resistance in 2011, and is theoretically a key round number (coincides with 1,350 on the S&P 500 Index), and the ingredients were in place for a potential move to this strike by Friday's expiration.

30-Minute Chart of SPY since November 9

SPY November Open Interest Ahead of Expiration Friday

Admittedly, there was a catalyst for the Friday reversal from the morning lows, as news came out that Democrats and Republicans were making progress on budget talks, an uncertainty that has cast doubt among many market participants, particularly after the November elections. As these talks progress, be on the lookout for various headlines surrounding the "fiscal cliff" negotiations to move markets one way or the other.

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 find it intriguing that May 2012 expiration week followed a very similar script (delta-hedge decline), as the 14-day Relative Strength Index (RSI) reached an oversold reading of 23 ahead of a Monday morning pop higher. This past week, the 14-day RSI reached an oversold 26 reading. The risk in using an oversold indicator is that oversold can stay oversold, and right now the primary short-term trend is lower.

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 (the dashed horizontal line on the chart below). This week, the SPX finds itself sitting in the area of various 2011 calendar-year highs (solid line on chart below). 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.

Daily Chart of SPX since April 2011 With 14-Day RSI

With the uncertainty regarding the imminent "fiscal cliff," the question on everyone's mind is, "Is the worst behind us in regards to the action during the past few weeks?" From a technical perspective, we think the SPX's 2011 highs in the 1,340-1,350 area must hold, even if this is part of a basing process instead of a "V"-type rally. If not, we are at risk of a move down to the June low in the 1,280 area.

From a sentiment perspective, we are seeing some signs that fear is reaching an extreme among market participants. For example:

1. The most recent American Association of Individual Investors (AAII) poll is showing the most bearish reading since the August 2011 bottom, suggesting those retail players that are actively engaged are not feeling good about the market's prospects.
2. Equity option buyers, who grew optimistic right ahead of the election, are downright pessimistic, as the five-day put/call volume ratio is trading around extreme lows.
3. Total short interest on SPX components remains just below the levels of this time last year, which means the short-covering play is still intact. The caveat here is the shorts are feeling a lot less pain now than a few weeks ago, so the urge to cover is not as great now.

Notice above that I bolded the word "some." I did this because we are not seeing extremes in negative sentiment in the National Association of Active Investment Managers (NAAIM) survey -- not like extremes that have marked past bottoms. Note that these investors were extremely bullish at the top, and many seem to be holding on to this view. This is a risk to the bullish case.

We remain bullish, and one way to manage the bullish view is the purchase of exchange-traded fund (ETF) puts, as the CBOE Market Volatility Index (VIX - 16.41) has remained low, and it's still below the area that is 50% above the 2012 low. With SPY 20-day historical volatility around 15%, at-the-money put options expiring Dec. 22 are reasonably priced at around 17% implieds. Such insurance may allow you to better sleep at night as discussions in Washington proceed.

NAAIM Sentiment Survey since 2011

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