Monday Morning Outlook

Why We're Eyeing the Latest Surge in VIX Call Buying

Heavy SPY call open interest could act as an expiration-week hurdle

by 4/13/2013 9:01:09 AM
Stocks quoted in this article:

The major equity indexes racked up healthy gains last week, with the Dow and S&P 500 blazing a trail to new record highs along the way. While this technical breakout has caused some pain for short sellers, can stocks now find the momentum to conquer the next wave of round-number hurdles? As we enter April expiration week, Todd Salamone explains how option mechanics could impact the market's next move. Meanwhile, Rocky White runs the numbers to see which indicators are working for technicians in the current market environment.

  • Small-caps and mid-caps run into trouble at ... half-century marks?
  • The crucial SPY strikes to watch as April options expire
  • 23 stocks flashing buy signals

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: Big-Caps Soar as Small-Caps Sputter
By Todd Salamone, Senior V.P. of Research

"The new record closing high on the SPX on Thursday could pressure more shorts to cover ... "
- Monday Morning Outlook, March 29, 2013

" ... from a contrarian perspective, the sentiment backdrop suggests the pullback to the 40-day moving average last week could precede a breakout above the recent range, as there is more buying power now relative to a few weeks ago. Active investment money managers have reduced market exposure, short interest continues to grow, and, once again, earnings season is being approached with skepticism ... "
- Monday Morning Outlook, April 6, 2013

"$SPX component short interest down 5.0% since last report, but still up 3.2% since Feb's YTD low. Up 11.7% YoY, SPX +10.5% YoY (as of 4/1)"
- @toddsalamone on Twitter, April 10, 2013

"A gauge of hedge-fund bullishness measuring how much they're betting on rising shares stands at 51.6 percent today, up from 47.3 at the end of 2012, according to data compiled by International Strategy & Investment Group."
- Bloomberg, April 10, 2013

Within the space of two weeks, the S&P 500 Index (SPX - 1,588.85) has broken out above its previous all-time closing high at 1,565.15 (solid horizontal line on graph below) and its intraday all-time high of 1,576.09 (dashed horizontal line on graph below), both set in 2007. As we observed last week, a combination of growing buying power relative to late January and another moderate pullback to significant moving-average support primed the index for a breakout. Within the blink of an eye, the SPX was trading just below its next potential hesitation point -- the round 1,600 area -- as the popular Dow Jones Industrial Average (DJI - 14,865.06) set its sights on the next major millennium area, 15,000. For what it's worth, the 5,000 millennium mark on the Dow was easily overcome in late 1995/early 1996, and bulls hope for a repeat with respect to 15,000.

 30-Minute Chart of SPX since March 4, 2013

In light of the SPX breakout, a concern we continue to have is the inability of the Russell 2000 Index (RUT - 942.85) and S&P 400 MidCap Index (MID - 1,149.23) to break out above their respective half-century marks at 950 and 1,150, respectively. In fairness, the MID has only challenged the 1,150 area two times since the end of March, and hit an all-time high in Thursday's trading. But the troubles with RUT 950 are more evident, as illustrated in the chart below. This price action is something we would expect more so around 1,000 versus 950 in the context of other benchmarks hitting all-time highs.

 30-Minute Chart of RUT since March 4, 2013

As you can see by the chart below, the shorts have felt the pain of an advancing market, with short interest decreasing during the latest reporting period. This likely accounts for the strong bid for equities that occurred on SPX pullbacks to the 1,540-1,550 area, which resulted in quick, short-term rallies during the past few weeks. When the mid-April data is released, we'll have to see if short covering continues to be supportive, as there's a good chance that those betting against certain components of the SPX bolted for the exits when the index broke into new-high territory. The good news for bulls is that short interest is significantly above year-ago levels, and there's a lot of room for total short interest on SPX components to move down to the lows that we saw in 2011 and 2012.

It is likely that hedge funds are reducing short exposure and thus increasing their bullishness on the market. Per the Bloomberg excerpt cited above, a measure of hedge-fund bullishness increased from 47.3% at the end of 2012 to 51.6% this past week. For perspective, the reading was at 43.9% at the beginning of 2012, and a reading below 50 suggests a bias toward short bets. Our takeaway is the hedge-fund crowd is far from euphoric, as they are barely in a net long position -- even with major averages and indexes hitting all-time highs.

 SPX with Total Short Interest since January 2011

Meanwhile, the call-buying machine on CBOE Market Volatility Index (VIX - 12.06) futures continues, with the 20-day buy-to-open call/put volume ratio soaring above 3.00 for the fifth time since January 2012. As you can see in the chart below, the SPX has tended to rally after such spikes, with the exception of the spike that preceded last year's September-November pullback. This particular spike occurred at the tail end of a sharp rally in the SPX, much like the current rally we are experiencing. That said, if the latest VIX call buying surge is again foreshadowing a correction, the odds are that the pullback continues after VIX options expire (which happens to be this coming Wednesday), as VIX spikes concurrent with market weakness have tended to happen after VIX expiration, when many call options expire worthless.

 VIX 20-day BTO call-put ratio since 2012

As you prepare for expiration week trading, be aware of the April open interest configuration on the SPDR S&P 500 ETF (SPY - 158.80) in order to pinpoint areas of potential support and resistance during the week. As you can see, we head into expiration week with the SPY trading around major call open interest strikes. So unlike most expiration weeks, where short covering related to expiring put open interest could be supportive, this will not be the case in the upcoming days, as major put open interest is far out of the money and thus less influential (unless a major event generates a sharp move lower, at which point these heavy put strikes could become magnets).

In fact, the rally that has occurred since Friday, April 5, could be driven in part by (a) an unwinding of short positions related to April put open interest that has become less sensitive to SPY price action, and (b) delta-hedge buying related to call open interest overhead that has experienced an increase in sensitivity to SPY movement. Based on the open interest configuration detailed below, it is possible that the 160 strike caps any upside in the SPY, while the 155-156 area could be supportive on a pullback as the mechanics of option expiration are at work.

 SPY April Open Interest

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