Global concerns were top of mind throughout the week. Tensions continued to flare in Ukraine, and all eyes turned toward Crimea, which will vote Sunday on whether to declare itself part of Russia. Elsewhere, concerns about the state of China's economic growth prospects weighed on equity and commodity markets. Amid the ensuing selling pressure, the Dow Jones Industrial Average (DJI) closed in the red for five consecutive sessions, and both the Dow and S&P 500 Index (SPX) finished Friday with their worst weekly deficits since late January. With this move, the SPX breached recent chart support -- but as Todd Salamone notes this week, the benchmark index continues to sit comfortably north of some critical levels. Meanwhile, as we head into options expiration week, speculative activity could impact the broader market as options players jockey for position.
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: Why to Watch Out for Delta Hedging
By Todd Salamone, Senior VP of Research
"The next couple of weeks could test the upward momentum that began in early February, with equity benchmarks entering next week's trading in an overbought condition, similar to that when we entered 2014 ... With short-term optimism among traders returning, and major benchmarks trading around potential resistance areas, the bullish momentum that began in early February is at risk of slowing, increasing the likelihood of choppy price action or downside movement in the coming days."
-Monday Morning Outlook, March 8, 2014
"$SPX back in red for '14 ... $RUT 11 points above YTD B/E and $MID 16 points above YTD breakeven"
"$VIX and $SPX slightly higher - $VIX almost double $SPX historical- likely due to Sunday's uncertainty- Crimea vote to secede from Ukraine."
-@ToddSalamone on Twitter, March 13 and 14, 2014
"'It's a way to hedge yourself against an accident,' said Frederic Jamet, a money manager at State Street Global Advisors France in Paris, in a phone interview on March 10. 'Many people feel they may have to protect themselves given that we haven't had a big stress moment in markets for a while.'"
-Bloomberg News, March 13, 2014, referring to the resurgent demand for the VelocityShares 2x VIX Short-Term ETN (TVIX)
Good news: U.S. equities are no longer in the short-term overbought condition that we observed in last weekend's report. Plus, key "risk on" indexes, such as the Russell 2000 Index (RUT - 1,181.41), S&P 400 MidCap Index (MID - 1,364.10), and Nasdaq Composite (COMP - 4,245.40) remain above year-to-date (YTD) breakeven levels, which represent potential support. These levels, respectively, are 1,163.64, 1,342.53, and 4,176.59.
Bad news: The decline that occurred last week pushed the S&P 500 Index (SPX - 1,841.13) back below the important 1,850 half-century mark and its YTD breakeven level of 1,848.36. Moreover, the SPX is not yet in an oversold condition, as measured by its 14-day Relative Strength Index (RSI). Bottoms have usually occurred when the RSI reaches the 25-30 area, with the current reading around 48.
How long the SPX remains below breakeven and whether or not "risk on" indexes will stay in positive territory could be determined rather quickly. Traders head into expiration week -- CBOE Volatility Index (VIX - 17.82) expiration on Tuesday, standard expiration Saturday -- amid a growing cloud of uncertainty once again, specifically with respect to the conflict between Russia and Ukraine. On Sunday, the citizens of Crimea vote to determine whether or not the region should secede from Ukraine and become part of Russia.
Such uncertainty can be quantified through volatility and options analysis, as the VIX trades at nearly a 100% premium to actual volatility. Moreover, in Friday's trading, more than 1.5 million VIX call contracts traded, which appears to be the second highest call volume on record. While some of the volume may be related to rolling activity (closing March options that expire this Tuesday and opening new options with April or May expiration dates), one could assume that there was a heavy dose of demand for portfolio protection.
The past two times that VIX call volume approached Friday's levels following a pop in the VIX, a VIX peak was in place (October 2013 and early February). Bulls can take some comfort in this fact, although there are no guarantees that the outcome of this upcoming event will be viewed as a positive for investors.
Additionally, the VIX enters next week's trading 50% above its 2014 lows, and many (not all) VIX peaks have occurred after advances of this magnitude off a key low.
A risk to bulls would be this week beginning on a sour note, as expiration-week declines are sometimes exacerbated by a process called delta hedging, which relates to the big put open interest below the market. When delta hedging occurs, sellers of the puts short more and more S&P futures to hedge against further declines in the market, and as the puts become more and more sensitive to the movements in the market, shorting activity increases, adding gas to the fire. Essentially, heavy put strikes become magnets during the delta-hedge process. The graph immediately below illustrates March expiration put and call open interest on the SPDR S&P 500 ETF Trust (SPY - 184.66). SPY 180 is roughly 1,800 on the SPX, with the SPY 1/10th of the SPX's value.
Conversely, a potential positive for bulls would be an "unwinding" of the short positions related to the put open interest, which could occur if the market stabilizes and sellers of the puts are at decreasing risk of the put options increasing in value.
Per the second chart below, one area of potential support on the SPX is the round 1,800 century mark. This is the site of the last heavy put strike in the March series, plus the site of the index's 120-day moving average, which has had recent importance. Moreover, a trendline drawn through higher lows since June rests at this level. Resistance is in the 1,848-1,850 area, with another layer of resistance around the recent high of 1,880.
The Case for Big Moves in IWM and QQQ
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