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Anxiety Heats Up, But VIX Cools Off

Weighing COMP's underperformance against the SPX's leadership

by 4/18/2014 9:30:00 AM
Stocks quoted in this article:

The holiday-shortened trading week was kind to stocks, with the major equity indexes racking up gains of more than 2%. Along the way, traders cheered earnings from the likes of Citigroup (C), Intel (INTC), and Yahoo! (YHOO) -- and some accommodative remarks from Fed Chair Janet Yellen certainly didn't hurt the bullish case. This week, Todd Salamone explains why April expiration may have also contributed to last week's bounce, and how the start of a new options cycle could impact the days ahead.

  • The key sentiment signs that point to waning risk appetites
  • Why VIX call buying could be a short-term risk for the bulls
  • Rocky White discusses what the tech slump means for the broader market

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 Optimism Balloon Finally Deflates
By Todd Salamone, Senior VP of Research

"As major benchmarks test areas of potential resistance, short-term traders who were extremely optimistic ahead of the decline in January and quickly turned into "Nervous Nellies" at the bottom in early February have once again changed their tune. The current optimism among traders, who turned optimistic as the market made new highs, leaves the market vulnerable to weakness in the days ahead."
-Monday Morning Outlook, March 8, 2014 (SPX - 1,878.04)

"The most notable benchmarks testing potential round-number support are the Nasdaq Composite (COMP - 3,999.73) and Dow Jones Industrial Average (DJI - 16,026.75), which are perched near their respective millennium levels at 4,000 and 16,000. In fact, bulls are hoping the 4,000 level can mark support once again for the COMP, as it did in late 2013 and at the early February bottom ...."

"Encouraging for bulls is that it is possible that some of this sell-off could be attributed to delta hedging, which is likely to end if stocks can stabilize slightly below or above the 180 level on the SPY and 110 level on the IWM ... if equities continue their downward trajectory, delta hedging could generate a temporary move below these put-heavy strikes, meaning round-number century marks, such as SPX 1,800 and RUT 1,100 would be violated."

"... VIX futures options expire on Wednesday, with the peak call strike at 18. Coincidentally, this is 50% above the VIX January low, and as we have mentioned before, multiple VIX peaks have occurred at an area 50% above its YTD low or a recent low."

-Monday Morning Outlook, April 12, 2014

"Data on sector exchange-traded funds also showed a big move out of tech-related areas, with science and tech ETFs registering outflows in the week ended April 9 after at least five straight weeks of inflows."
-Reuters, April 14, 2014

"Hedge funds are saying goodbye to the calm that blanketed U.S. stocks for the past two years. Large speculators have reduced bets on lower volatility ... The percentage of hedge fund holdings that amount to bets that stocks will rise has decreased to 46 percent from 58 percent earlier in the year, a sign of selling, according to an April 9 research note from Credit Suisse Group AG. Net exposure in the U.S. declined to the lowest level since August 2012, the report said."
-Bloomberg Businessweek, April 14, 2014

They're back! Who? The "Nervous Nellies" that finally turned optimistic in early March, after the February rally and just ahead of several weeks of market weakness. The optimism in early March preceded a modest decline in the S&P 500 Index (SPX - 1,864.85) and a near 10% correction in the Nasdaq Composite (COMP - 4,095.52). The COMP's Tuesday low was at 3,946, site of its 200-day moving average, and just 12 points above the 3,934 level that would mark a 10% correction from the March highs. The rally from this trendline was powerful, as the COMP managed to hold above the key 4,000 millennium mark that we discussed last week.

Daily Chart of COMP with 200-Day Moving Average
10% correction (almost)
COMP with 200-Day Moving Average

Moreover, and at risk of sounding like a broken record, it was round-number millennium and century marks that proved to be supportive at last week's lows, after these same benchmarks failed to overtake round-number levels over the course of the past few weeks. For example, the Russell 2000 Index (RUT - 1,137.90) -- after experiencing a failure at 1,200 in March -- rallied strongly from the 1,100 level, which has been supportive since December. Moreover, the Dow Jones Industrial Average (DJI - 16,408.54) put in lows last week at 16,015 and is now only 168 points below its 2014 breakeven level of 16,576.66. The DJI has not closed above this level in 2014, although it peaked above it on an intraday basis at the beginning of the month.

In fact, we spent time last week discussing the possibility that the sell-off in the second week of April was delta-hedging related, and that a continuation of this might create a temporary move below round-number support levels. Judging by the behavior of the iShares Russell 2000 ETF (IWM - 112.92), which bottomed last week around its last put-heavy April open interest strike and round-number 110 support, which represents RUT 1,100. Selling related to delta hedging dried up, allowing this small-cap ETF to stabilize -- and after a move above 110, it was likely the unwinding of short positions related to expiring put strikes that drove the rally into Thursday's expiration. In other words, the action last week that was characterized by a steady dose of selling followed by a quick, sharp rally was likely related to various mechanics at work related to April options expiration.

30-Minute Chart of IWM
Brief move below the last major put open interest strike at 110,
followed by pop higher as delta-hedge selling was exhausted
30-Minute Chart of IWM

As the dust settles following what appears to be expiration-related selling and buying (or short covering), many benchmarks find themselves around year-to-date (YTD) breakeven levels, with the DJI and RUT in the red, while the SPX and S&P 400 MidCap Index (MID - 1,351.42) closed back in positive territory for the year. Moreover, the Wilshire 5000 (W5000 - 19,832.16), after a brief move below its YTD breakeven at 19,706.03, rallied back above YTD breakeven, but still finds itself below the mighty 20,000 millennium level, which has proven to be a major nuisance for bulls.

The price action the past few weeks has deflated the short-term optimism balloon that was floating high at the beginning of March. As excerpted above, last week there were finally outflows from equity exchange-traded funds that are typically deemed "risky," and hedge funds have reduced their equity exposure. Moreover, equity option buyers are showing an increased penchant for puts, with the 10-day buy-to-open put/call volume ratio at 0.56 -- the most elevated level since early September, which was a good time to be in stocks.

Finally, as reported in a Bloomberg Businessweek article last week, the short volatility trade (bets on a volatility decline that occurs with an advancing equity market) is not nearly as popular as it once was among volatility speculators. We find this interesting, especially after (another) CBOE Market Volatility Index (VIX - 13.36) peak in the 18 area, the significance of which we discussed last week, as it is 50% above the 2014 closing low. The VIX indeed peaked around this level, and still has room to fall.

Daily Chart of VIX
Horizontal line marks YTD breakeven
Three consecutive intraday moves above 2013 close, but three closes below it
Daily Chart of VIX

That said, a short-term risk to equity bulls, in addition to the RUT and DJI trading below YTD breakeven levels, is that the VIX is trading nearer to the lower boundary of a two-month range. And with 2.6 million VIX call contracts expiring last week, those looking to hedge long portfolios may seek protection by way of VIX call buying, which can be a coincident headwind for stocks, as sellers of these calls look to short S&P futures as a hedge.

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