Why VIX Call Volume Could Be Set to Surge This Week

With Washington, D.C., facing a March 1 deadline, the protection trade is alive and well

by 2/16/2013 9:25:31 AM
Stocks quoted in this article:

It was an uneventful week for U.S. stocks, as the major market indexes finished nearly flat. Granted, the small-caps and mid-caps tagged some fresh highs -- but momentum more or less fizzled as investors stared down a currency-focused G-20 meeting and a long holiday weekend. With February expiration week in the rear view, are stocks set to resume their uptrend? This week, Todd Salamone explains the key indicators bulls should be watching in post-Presidents Day action.

  • How the "protection trade" could impact equities in the weeks ahead
  • Why historical trends suggest this rally still has legs to run higher
  • Rocky White's list of outperforming stocks analysts love to hate

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: Keep Playing the Current Momentum
By Todd Salamone, Senior V.P. of Research

"For those trading during expiration week, the market usually experiences weakness in the immediate days following VIX expiration, perhaps due to VIX call buyers looking to replace expired options ... If you follow the SPDR S&P 500 Trust (SPY), the current open interest configuration suggests the SPY could trade between 150.00 and 152.00 next week ... The February 152 strike is home to more than 300,000 open calls, most of which were purchased options. Sellers of the options would like to see the SPY finish below 152.00 on expiration Friday."

"... there were two uncommon moving averages that supported market pullbacks in 2012's first quarter (and, for what it is worth, the first two months of 2011, too). Specifically, the SPX's 15-day and 30-day moving averages provided support during these momentum days and, once broken, signaled notable pullbacks. I find these trendlines of interest ..."

-Monday Morning Outlook, February 9, 2013

"$VIX call volume 1.5x's normal, put volume half normal"

"$SPX components short covering- half way through this ball game if short interest hits '12 lows"

-@ToddSalamone on Twitter, February 13, 2013

With February expiration week behind us, the good news is that the S&P 500 Index (SPX - 1,519.79) reached another multi-year high, while the S&P MidCap 400 Index (MID - 1,115.75) and Russell 2000 Index (RUT - 923.15) notched all-time highs during the week. But the Dow Jones Industrial Average (DJIA - 13,981.76) failed to close Friday above the 14,000 millennium mark, and the SPX finished the second half of the week in the red.

The expiration of CBOE Market Volatility Index (VIX - 12.46) options on Wednesday morning slowed the market's momentum early in the week, as VIX call buyers stepped up and replaced expiring options -- evidenced by strong volume on Wednesday and Thursday. Such activity has a capping effect, as sellers of the VIX calls will likely hedge by shorting S&P futures.

Additionally, the big February 152 call open interest on the SPDR S&P 500 Trust (SPY - 152.11) proved challenging during the course of the week, with the strike being touched several times Tuesday through Friday. In fact, we observed huge liquidation of the purchased calls from Feb. 4 that may have pressured stocks about two hours before the close on Friday, before the SPY rebounded in late-afternoon trading to close around 152.00.

 SPY - February Expiration Week

 VIX Expiration Week Call Volume

In the upcoming holiday-shortened week, minutes of the Federal Open Market Committee's (FOMC) January meeting will be released on Wednesday, and investors will likely be looking for hints that quantitative easing efforts are about to end. Tuesday morning's action -- and, in fact, the next couple of weeks -- could be influenced by a build in index and exchange-traded fund (ETF) put options and VIX call options, as the protection trade that has been prominent throughout the rally continues.

In fact, with the VIX hitting another multi-year low on Friday, call options will likely be in high demand. Volatility, as measured by the VIX, may creep higher into the beginning of March, as automatic spending cuts are due to kick in on March 1 and an intense focus on Washington, D.C., may again predominate as we get closer to this date. Additionally, the financial sector will be a point of focus at the beginning of March, with stress tests and government decisions on banks' capital plans due to be released.

Short covering continues to be supportive of the current advance, with any market "setbacks" this year being characterized as very mild or simply sideways movement, or contained to those heavily invested in assets such as gold and bonds. If short interest on SPX component stocks eventually reaches 2012 lows, one could argue that we are only at the mid-point of the short-covering rally. One positive, from a contrarian perspective, is that some sentiment indicators have turned less optimistic during the current consolidation phase. But any perceived negative news out of Washington, D.C., in the coming weeks could once again embolden the shorts and reverse the current covering trend.

 SPX Stocks with Total Short Interest

A combination of looming spending cuts, Dow 14,000, the SPX trading around its 2000 highs, and the "we have come too far, too fast" mentality has some thinking that we're due for a correction of about 5%. But as we discussed in prior weeks, if we repeat the first quarters of 2011 and 2012, this rally could have more gas left in the tank -- and this theory is reinforced by the idea that short interest, at present, is about where it stood last year. For now, we are playing the current momentum in the market, and focusing on uncommon moving averages -- such as the 15-day and 30-day trendlines -- as signposts that could reveal whether momentum is apt to continue or slow down.

 Daily Chart of SPX since January 2012 With 15-Day and 30-Day Moving Averages

Our favorite sectors include Internet-related names and homebuilders, while we would avoid gold and gold-mining stocks.

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