Stocks enjoyed a much-needed bounce last week, as traders priced in some optimism over the prospect of additional stimulus -- despite a characteristically deadpan appearance by Fed Chairman Ben Bernanke on Capitol Hill. Following the market's best weekly performance of 2012, it's safe to say the technical outlook has improved. But can stocks keep chugging higher, or are we simply teetering on the precipice of another leg lower? As we head into June expiration week, Todd Salamone tries to determine if heavy put open interest on the SPDR S&P 500 ETF (SPY) could play havoc with traders' bullish aspirations. Todd also highlights the major support and resistance levels to watch -- including that troublesome double-low for the S&P 500 Index (SPX). Of course, we can't forget the index's popular 200-day moving average, which Rocky White puts under the microscope in his weekly analysis. After this benchmark trendline was breached and reclaimed in a matter of mere days, Rocky runs the numbers to determine how previous breaks of this moving average have played out for the SPX. Finally, we wrap up with a look at this week's notable earnings and economic events, as well as a few sectors of note.
Notes from the Trading Desk: What Are the Odds of Another Delta-Hedging Downturn?
By Todd Salamone, Senior VP of Research
"The sentiment backdrop continues to grow more pessimistic and remains consistent with negativity seen at major bottoms during corrective pullbacks the last few years... The risk to bulls is that the sentiment backdrop worsens from here, but bears should also be on guard for a reversal in the sentiment backdrop, as major short-covering could follow.
"If you are looking to enter long positions, a pullback to the SPX breakeven point or a VIX move into the 27-28 area could present decent entry points for potential short-term rewards, but keep your stops tight in the event the current pullback has more life in it."
In our last report, we discussed the technical deterioration in the market, as the Russell 2000 Index (RUT - 769.19) had dropped below the key 750 area and into the red for 2012; the Dow Jones Industrial Average (DJIA - 12,554.20) had slipped into negative territory; the S&P 500 Index (SPX - 1,325.66) fell below its 320-day moving average at 1,290; and the CBOE Market Volatility Index (VIX - 21.23) was rallying from former resistance levels 50% above its March intraday and closing lows.
But speculation that the Federal Reserve may ease monetary policy in the near future -- along with a surprise interest-rate cut from China's central bank -- acted as fuel for a short-covering rally, pushing the RUT back into the green year-to-date, and back above the 750 area. Meanwhile, the S&P MidCap 400 Index (MID - 925.98) rallied above the 900 century level, which marked its peak in 2007. Moreover, the SPX bounced back above the popular 200-day moving average and the more critical 320-day moving average, closing above the round-number 1,300 region for the week.
So, just as the technical backdrop grew more ominous in late May and on the first trading day of June, the picture improved slightly in June's first full week of trading. In fact, bulls might be encouraged by the VIX's peak at 27.73 early in the week -- within the vicinity of the 27-28 area that we advised last week was a good spot to initiate long positions, as it marks double the VIX's March lows. As we have said in the past, while there is nothing exact in its behavior, the VIX has an uncanny tendency to peak at levels 50%, 100%, 150%, or 200% above past recent lows, while pulling back to find brief support at half highs.
As a sidebar to our VIX discussion, we'll note that some strategists and option analysts are looking for a VIX above 30 before all is said and done. For contrarians, should the VIX's peak last week remain in place, those banking on the index to take out 30 before initiating new long positions or closing short positions may represent future buying power, since the much-watched 30 level was not breached.
The technical backdrop improved last week, but the bulls are not out of the woods. The VIX comes into the week near potential support, and there are a slew of key potential resistance levels just above the SPX's weekly close.
For example, as you can see on the chart above, the VIX enters the week trading at potential support 50% above its March lows. This area has contained three separate pullbacks since late May, which have coincided with weakness in the equity market.
Meanwhile, the SPX faces resistance at several key levels, including:
On Thursday, for the second time since late May, the SPX stalled in the 1,333 area after a sharp rally up to this level. Moreover, the SPX has ventured above 1,320 eight times since the move below this level on May 17, but has closed above it only three times, including last Friday's finish.
Unfortunately, the only certainty this weekend is that Kentucky Derby and Preakness Stakes winner I'll Have Another will not win the prestigious Triple Crown, after pulling out of the Belmont Stakes on Friday. The uncertainty this weekend is how the European Union will deal with Spain's ailing bank sector. Talks between senior finance ministry officials are due to begin on Saturday, and progress on this situation could easily dictate the market's direction next week -- which also happens to be expiration week.
The current open interest configuration on the SPDR S&P 500 ETF (SPY - 133.10) is very put-heavy, setting up the potential for short-covering related to the expiring put open interest at strikes immediately below the current SPY price. The odds are in the bulls' favor, absent a negative outcome with respect to Spain over the weekend. That said, a poor start to the week spurred by ongoing euro-zone concerns could create the kind of delta-hedge selling that occurred last expiration month, when put strikes acted as "magnets" once the ball got rolling to the downside.
It's usually the big put strikes that act like magnets, so 128 (which corresponds to SPX 1,280) would be a possible support area. There's a smaller-probability risk of a move down to 125 (or SPX 1,250), which is the next strike with significant put open interest. On the upside, a move into heavy call strikes at 134 and 135 would be a possibility in the event of a short-covering rally. These areas correspond to SPX 1,340 and 1,350, respectively, which we cited above as potential chart resistance.
The one caveat when comparing May expiration against June is that at this point in the cycle, May put strikes had upwards of 300,000 and 400,000 contracts at single strikes, implying delta-hedge selling or short-covering potential this month may not be as great relative to May.
The Case for Big Moves in IWM and QQQ
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