Visiting the Ghosts of Expiration Weeks Past

Despite a low VIX, volatility traders have found profitable opportunities

by 12/15/2012 9:32:51 AM
Stocks quoted in this article:

Aside from the Fed's renewed monthly commitment to repurchase $45 billion in Treasuries, the absolute lack of news on the fiscal-cliff front was the real story of the week. As party leaders become increasingly frustrated with the lack of compromise from the other side, investors worry this game of political chicken will yield no resolution by the year-end deadline. Against this backdrop, the major market indexes retreated slightly on the week, but Todd Salamone remains solidly bullish as he anticipates the final expiration week of the year. And while the CBOE Market Volatility Index (VIX) remains at relatively low levels, Rocky White explores where volatility has been hiding (and how options traders can cash in).

  • Why this week's options expiration may "not be as eventful as last month"
  • VIX levels to watch, for bulls and bears
  • These 20 stocks have been great for volatility traders

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: Similar, But Different -- Learning From Last Month's Expiration Trends
By Todd Salamone, Senior V.P. of Research

Next week is the last expiration week of the year, and when reviewing Monday Morning Outlook heading into November expiration week -- a week that was mired by a steady decline into expiration Friday before a reversal took hold -- I was struck by a couple of similarities between then and now.

Admittedly, the technical backdrop now versus then is stronger, as the S&P 500 Index (SPX - 1,413.58) was trading slightly below its 200-day moving average (currently at 1,387.50) last month, whereas now it is comfortably above this trendline. Headlines relating to the fiscal cliff were gaining momentum, just as they are now, and call buying on the CBOE Market Volatility Index (VIX - 17.00) was and is still hitting extremes, as it is almost a foregone conclusion that "volatility is headed higher."

Then, as is now, the 1,000 area on the S&P 400 MidCap Index (MID - 1,001.53) was "in play." Last month, the MID rallied above 1,000 the week prior to monthly options expiration, and quickly fell back below 1,000 before November expiration week. The MID again peeked its head above 1,000 ahead of this upcoming expiration week, only it remains barely north of this level as we head into December expiration.

Intraday Chart of MID since Nov. 6, 2012

In the week prior to November expiration, the S&P Depositary Receipts (SPY 142.11) ran into a call open interest wall just south of 144.00 before turning lower. This week, however, the SPY ran into a "call wall" just south of 145.00 before turning lower. In the former case, the SPY peaked around 143.50, and in the latter case, it peaked at 144.50.

In November, there was huge put open interest in strikes immediately around the Friday (Nov. 9), pre-expiration-week close of 138.16 (see the chart immediately below). The heavy put strikes during November expiration week acted as a magnets, since sellers of the puts (those selling portfolio insurance) likely sold equity futures to hedge their positions as the market weakened. This happens because the puts became more and more sensitive to the market's movement as the underlying SPY moved closer to the relevant strikes. The selling is known as delta hedging, which we think had a hand in accelerating the November expiration-week decline.

Ultimately, on expiration day (Nov. 16), a bottom was reached near 135, site of the last significant put open interest strike in the November series. In revisiting November, the break of the put-heavy 140 strike, with its nearly 500,000 open contracts, spelled a short-term doomsday, as this breach generated sharp, heavy selling of equities, quickly putting into play other heavy put open interest strikes immediately below.

Intraday Chart of SPY since Nov. 6, 2012

The bad news for bulls is that in the event there is a catalyst of some kind to spark a heavy selloff, a repeat of November expiration is possible. But on the bright side, the probability of a serious delta-hedge decline occurring is less, as a break of the 140 strike should not be as influential as it was in November, since December put open interest at this round-number strike is much less (see the second chart below) relative to November expiration week (first chart below). In fact, we would not be surprised to see the SPY trade between the heaviest call and put strikes in its immediate vicinity, which -- translated to the SPX -- would be 1,400 and 1,450.

November SPY open interest configuration

December SPY open interest configuration

Finally, options on VIX futures expire this week (on Wednesday). Looking at the open interest configuration, there are big bets outstanding that the VIX will remain above 15, as the huge put open interest at this strike is made up of put sellers. A breach of this strike early in the week could panic the put sellers, and lead to a sharp decline in volatility -- and an ensuing market rally. And there are also big bets that a move above 20 occurs. For bulls, it would be disturbing to see a move through VIX 20 early in the week, as sellers of these calls would likely hedge via buying VIX futures or shorting S&P futures, pushing the VIX up to 25 in short order.

The bottom line is that while there are some similarities coming into November and December expiration weeks, we think there is a higher probability that this upcoming week will not be as eventful as last month. We still remain bullish -- as seasonality favors the bulls -- and the massive short position in the market could generate short covering at a moment's notice.

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