Monday Morning Outlook

Why a 'Pricey' VIX Could Support Stocks This Week

Find out the key S&P 500 level we're watching as fiscal-cliff drama unfolds

by 12/22/2012 10:32:38 AM
Stocks quoted in this article:

So, do legislators have a "Plan C" on tap for Christmas week? While December expiration was punctuated by a big fiscal-cliff disappointment, the major equity indexes managed to finish the week on positive ground. However, as evidenced by last week's VIX spike, there's still plenty of uncertainty hovering over this market. Fortunately, with just a couple of abbreviated trading weeks left in 2012, Todd Salamone and Rocky White have some glad tidings for the bulls.

  • Learn the crucial SPX level you need to monitor
  • Did the mid-caps finally clear this notorious round-number hurdle?
  • Find out whether bulls or bears have the historical edge during holiday trading

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: 3 Reasons We're Watching SPX 1,425
By Todd Salamone, Senior V.P. of Research

"... 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."
-Monday Morning Outlook, December 15, 2012

"$MID 1,026.85 all-time closing high on 9/14/12, this morning's intraday high 1,026.52"
-@toddsalamone on Twitter, December 19, 2012

" Very unique look by @toddsalamone on why $VIX expiration (happened yesterday) can be a headwind for $SPX near-term. $$"
-@RyanDetrick on Twitter, December 20, 2012

"One trend that stands out to us is the tendency for the VIX to advance immediately after the monthly expiration-related collapse in VIX call open interest."
-Monday Morning Outlook, November 24, 2012

"$VIX 19.93 high so far today, and 19.95 is 50% above August low. Multiple VIX peaks this year at 50% above prior '12 closing low."
-@toddsalamone on Twitter, December 21, 2012

As you can see from the various excerpts above -- including a combination of technical analysis, option open interest, and volatility analysis -- a pullback after the early expiration-week advance was not a major surprise. That said, the sharpness of the Friday-morning pullback under the circumstances that drove this move was a little bit surprising.

Last week, for example, we touched on key levels to watch during expiration week, based on our open interest analysis of a major exchange-traded fund (ETF), the SPDR S&P 500 ETF Trust (SPY - 142.79). Based on this analysis, we were projecting the possibility that the S&P 500 Index (SPX - 1,430.15) could trade between 1,400 and 1,450. The cash SPX never came close to 1,400, but did fail around the 1,450 level on Thursday. However, the S&P futures briefly traded around the 1,400 level in Thursday's overnight trading. The quick bounce back above 1,400 in the futures market was significant, and supported our remarks from last week:

"... a break of the [SPY]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 relative to November expiration week."

We were insinuating that a break of the 1,400 level would likely not lead to major delta-hedge selling that would beget further selling, like that which occurred around November expiration week. That said, the 140 strike may have acted as a magnet in the overnight hours, exacerbating the overnight selling, as those who were short 140-strike puts hedged by selling futures. When this delta-hedge selling ended, the futures market finally caught a bid.

 S&P Futures Last Week 1,390-1,445 Expiration Week Range

Another observation we made during the course of the week was that with options on volatility futures expiring, the market could face a headwind the rest of expiration week, and even beyond. On Wednesday, more than 2 million contracts expired on CBOE Market Volatility Index (VIX - 17.84) futures. As we remarked last month, the VIX has tended to pop soon after VIX expiration. And in an observation we posted this past Wednesday, entitled "VIX expiration today - what does this typically mean?", we noted that SPX returns are negative Wednesday through Friday of expiration week, whereas the Wednesday-through-Friday period during expiration week is typically positive when VIX options expire the week after expiration week.

The table and graph below will give you a glimpse of what we've been noticing in the immediate days after VIX expiration. The first table shows SPX returns when VIX options expire during expiration week, as opposed to the week after expiration (since 2010, when VIX options became popular). Per the Trade-Alert graph, in 2012, the VIX has had a tendency to advance immediately after VIX expiration and the coincidental plunge in call open interest.

 SPX Returns since 2010 - VIX Expiration

 VIX Daily Open Interest

As we move into an abbreviated trading week, the big question is, "Will VIX call buying and index/ETF put buying be brisk, now that volatility has popped?" On one hand, we could make the case that it will, as market participants continue to replace VIX call options that expired last Wednesday, while other market participants look to replace index and ETF put options that expired on Friday. But on the other hand, in the very near term, with holiday-related time decay threatening and volatility already popping, some may view portfolio insurance as too "expensive," which could be supportive of the market at a time when stocks normally face headwinds.

For example, note that the VIX peaked on Friday at a level 50% above the August closing low. Throughout most of calendar year 2012, and with the exception of only the April-May period, the VIX has had a tendency to peak around levels 50% above the prior calendar-year low. Should those that typically seek portfolio insurance decide to wait for a "better price," such a mentality could be supportive in the immediate days ahead.

 Daily Chart of VIX in 2012 with Key Levels

Despite the "cliff"-related negative surprise at the end of expiration week, bulls should be encouraged by the SPX's hold at the 1,425 area, which marks:

  1. The 61.8% Fibonacci retracement of the mid-September high and mid-November low
  2. Previous resistance in April and August
  3. Its 80-day moving average, which has marked support/resistance at various times during the past few years
 Daily Chart of SPX in 2012 With 80-Day Moving Average and Key Fibonacci Levels

Finally, while the S&P MidCap 400 Index (MID - 1,022.36) ran up to its September all-time closing high and sold off on Friday, we are encouraged that it has remained above the 1,000 millennium level for 13 consecutive trading days -- surpassing the 12-session streak in September, which was the previous record for consecutive days above 1,000. Has the MID finally cleared this hurdle, which has been in place since early last year? We think so, but stay tuned.

Thank you for taking the time to read our commentary during this busy time of year. We hope you're enjoying the holiday season.

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