What Caused Last Week's Broad-Market Downturn (and Will the Selling Continue)?

Dissecting a flaw in one highly publicized indicator

by 8/17/2013 10:19:02 AM
Stocks quoted in this article:

The week started off on a rather quiet note, however, disappointing turns in the earnings confessional from blue chips Cisco Systems, Inc. (NASDAQ:CSCO) and Wal-Mart Stores, Inc. (NYSE:WMT) became the catalyst to set the bearish wheels in motion. An upbeat weekly jobless claims report on Thursday fueled anxiety that the Fed will begin tapering bond-buying purchases sooner rather than later, and had investors hitting the exits en masse. By the time the closing bell mercifully sounded on Friday, the Dow Jones Industrial Average (DJI) was staring up its biggest weekly drop of 2013. Consequently, the yield on 10-year bonds soared to its highest level in two years. A review of the week's volatile backdrop prompted Todd Salamone to ask "What happened?" -- and explore what we can expect going forward.

  • The hand that delta-hedging may have had in this week's sell-off.
  • 4 reasons bulls should keep the faith.
  • Rocky White finds a flaw with the Hindenburg Omen.

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: The Expiration-Week Factor
By Todd Salamone, Senior V.P. of Research

"Next week is August options expiration, and if volume continues to languish as it did last week, we would not be surprised to see major exchange-traded funds (ETFs), such as the SPDR S&P 500 ETF Trust (SPY - 169.31) and the iShares Russell 2000 ETF (IWM - 104.04) trade between peak levels of put and call open interest that expires next Friday.... option premium sellers would love to see the SPY close next Friday between 169 and 170 to maximize the number of outstanding contracts expiring worthless. The SPY 170 level is equivalent to S&P 1,700, where sellers emerged late last week..."
-Monday Morning Outlook, Aug. 10, 2013

"With resistance lingering overhead, one sentiment indicator that we closely monitor is suggesting a higher-than-normal probability of a continued pullback in stocks...the 10-day moving average of the all-equity, customer-only, buy (to open) put/call volume ratio is back to the 0.50 area. The last time the ratio was at 0.50 was in May, and this preceded a 5% pullback over the course of the following month. The lower this ratio is, the more optimism there is among option speculators... this ratio is currently at the lower boundary of its two-year range and (with one exception) such optimism has come before pullbacks during the past couple of years."
-Monday Morning Outlook, Aug. 10, 2013

"$SPX MTD breakeven is 1,685.73. Support since 8/7 on pullbacks but in danger of giving way today "

"Index and ETF breaks below heavy put open interest strikes this close to expiration make delta hedging sell offs fair game $SPY $SPX $IWM"

"$SPY if delta-hedge selling is occurring, you can expect a floor at $165-$166, the last put strikes with significant open interest"
-@toddsalamone on Twitter, Aug. 15, 2013

What happened last week? And what does this mean moving forward?

Low volume was evident Monday through Wednesday, and it appeared the SPDR S&P 500 ETF Trust (SPY - 165.87) was on course to remain bound between 169 and 170 -- an area in which option premium sellers would maximize profits. However, volume and selling picked up on Thursday, after tech titan Cisco Systems, Inc. (CSCO - 24.27) and retail bellwether Wal-Mart Stores, Inc. (WMT - 74.11) reacted negatively to earnings and sales numbers, respectively. Moreover, a stronger-than-expected report on jobless claims sent both bonds and stocks reeling. In essence, it took a catalyst and stronger volume to finally move key equity benchmarks after days of, quite frankly, boring, directionless price action.

As we suggested on Twitter Thursday morning before the market opened -- with S&P 500 Index (SPX - 1,655.83) futures down nine points -- the break of chart support was one thing to ponder. Many technicians were focused on the 1,685 area as support, as this represents the site of the May high, as well as the month-to-date breakeven level.

Additionally, and perhaps more importantly, we remarked that a move below heavy put open interest on key indices and exchange-traded funds (ETFs) lays the groundwork for a delta-hedge selloff when expiration is near. Simply stated, sellers of the puts are forced to short S&P futures if they wish to remain neutral. In this scenario, out-of-the-money put strikes with significant open interest will act as magnets, as they increase in value and become more sensitive to the index or ETF as it retreats. As the puts' value becomes more sensitive to changes in the underlying index or ETF, shorting becomes more intense, creating a snowball effect until the premium sellers are fully hedged.

In our view, the gap below the put-heavy 169 strike just one day prior to expiration Friday may have induced "delta-hedge" selling. This in turn generated greater downside volatility than normal, as there were additional strikes with heavy put open interest below this key strike that acted as magnets. Put sellers had to scramble to short S&P futures as the SPY quickly moved toward or below the heavy put strikes. However, shorting intensity would decrease in the 165-166 zone and set up a potential floor, as put open interest was significantly lower at strikes below 165.

SPY August Open Interest Configuration as of Thursday Morning

30-Minute Chart of the SPY Since August 8

Do not forget that last week's decline occurred within the context of option traders showing an extreme level of enthusiasm for equities, as measured by the 10-day moving average of the equity-only, buy (to open) put/call volume ratio. We discussed this indicator in detail last week as one of the single biggest short-term risks to the market from a sentiment perspective. In fact, this ratio hit 0.465 coming into last Thursday's trading, its lowest reading since May 3, 2011.

If indeed last week's decline was driven in part by expiration-week mechanics, we would expect that this pullback goes no lower than the 1,640-1,650 levels on the SPX -- a support zone that we discussed last week. This area is around the index's 80-day moving average and a 15% year-to-date gain. But as we mentioned too last week, "A worst-case, lower-probability scenario is a pullback to the round-number 1,500 area, site of a trendline connecting lower highs since 2009 and a 12% decline from the recent peak."

If additional sentiment indicators were confirming the current enthusiasm evident among equity option players, we would place a lower probability on the current downside being limited to the SPX 1,640-1,650 area. But other sentiment indicators we follow are not registering the enthusiastic extremes evident in the options market. For instance:

  1. Hedge funds focusing on stocks gained 2.4% last month, significantly lagging the 5% gain logged by the SPX. This statistic confirms the clues we have observed suggesting that hedge funds remain underinvested and underweight equities.

  2. The percentage of advisors that are bullish in the latest Investors Intelligence poll is below 50%.

  3. The CBOE Market Volatility Index (VIX - 14.37) call buying relative to put buying is at its highest level since 2009, which means very few market followers are looking for lower volatility and higher stock prices ahead. Another interpretation is that the few fund managers that do have a big position in equities are doing so with extreme caution in mind, purchasing VIX calls to hedge long positions.

  4. Short interest on SPX component stocks is at the higher end of a two-year range, and roughly 20% above the May 2012 lows. This would suggest that short players that are experiencing losses may be looking to cover, especially if the market stabilizes again on this latest pullback. Should stocks continue to decline, they may not feel the urge to cover.

Last week, we advised buying the dips. This advice holds true, as long as the SPX remains above the 1,640-1,650 area.

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