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What Are Bulls Hiding in Their Arsenal?

Pessimism among short-term traders remains at extreme levels

by 8/16/2014 8:19:46 AM
Stocks quoted in this article:

Markets experienced notable moves on both sides of breakeven last week, as traders cheered -- then jeered -- a slew of geopolitical developments. By the time the dust settled on Friday, though, all three major indexes were sitting on healthy week-over-week gains. Although a number of key benchmarks we track are trading near resistance levels, Schaeffer's Senior VP of Research Todd Salamone explains there is more than enough "firepower" on the sentiment front to push through these technical speed bumps.

  • 2 encouraging sentiment indicators for those with a bullish outlook
  • What makes this VIX expiration different from the rest
  • Why contrarians should cheer the recent trend among option buyers

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: Round-Number and YTD Breakeven Levels Come Back Into Focus
By Todd Salamone, Senior VP of Research

"... the SPX's 120-day moving average sits just below at the round 1,900 level ... since early 2013, this trendline has marked numerous troughs, as it has coincidentally come into play around half-century and century marks. Even though the SPX broke below the more popular 50-day moving average again this week, such breaks have proven to be more bullish than bearish since 2013."
-Monday Morning Outlook, Aug. 2, 2014

"In the absence of any new negative surprises on the geopolitical (or domestic) front next week, bulls could benefit from the opposite mechanics of delta-hedge selling. That is, as August put contracts at strikes below the market get set to expire, short covering associated with the expiring put open interest could create a tailwind, especially with the SPY coming into expiration week above the put-heavy 192 strike ... the short-term sentiment backdrop now suggests that there is more reward than risk over the next month."
-Monday Morning Outlook, Aug. 9, 2014

"$VIX back below its YTD B/E mark at 13.72 for first time since 7/30"

"Since April '12, $SPX component short interest up 25% with $SPX up almost 40% over same time frame"
-@ToddSalamone on Twitter, Aug. 13-14, 2014

Amid a sentiment backdrop that continues to support the bullish case, round numbers and year-to-date (YTD) breakeven levels have come into play during the past couple of weeks on a few key benchmarks that we follow. Specifically, the S&P 500 Index (SPX - 1,955.06) and Russell 2000 Index (RUT - 1,141.65) bounced strongly off support at 1,900 and 1,100, respectively, beginning the week before last.

This week, it was all about YTD breakeven levels on the Dow Jones Industrial Average (DJI - 16,662.91) and a key volatility benchmark -- the CBOE Volatility Index (VIX - 13.15). The DJI slipped below its YTD breakeven mark at 16,576 on the last trading day of July, and it finally closed back above this level on Wednesday, following a few unsuccessful attempts to close back in the green for 2014 in the days prior.

As the DJI struggled to break back into the green, the VIX struggled to move back into negative YTD territory below 13.72. Following a spike above this level at the end of July -- and a move above 15.48, which is 50% above the July low -- the VIX ultimately peaked roughly 70% above its July trough. With the market rallying on the heels of potential short-covering related to expiring index and exchange-traded fund (ETF) options, the VIX imploded this past week, although the YTD breakeven level at 13.72 temporarily halted the volatility slide on Monday afternoon and in early trading on Wednesday. The VIX's gap back below 15.48, and the decline below the 2013 close this week -- combined with the SPX's strong move off of support -- is encouraging for those with a bullish outlook.

DJI 30-Minute Chart -- YTD breakeven (horizontal line) has been significant during the past several days

30-Minute DJI Chart Since July 29

VIX 30-Minute Chart -- A move back below 15.48 (50% above July low) and 13.72 (YTD breakeven) could potentially be a short-term buy signal

30-Minute VIX Since July 24

Now, we head into this week with other key benchmarks trading around either round-number levels, or round-number YTD percentage gains. For example, the S&P 400 MidCap Index (MID - 1,395.50) is trading around the 1,400 mark once again, which marked a peak in April ahead of a pullback to the 1,300 level. Meanwhile, the PowerShares QQQ Trust (QQQ - 97.40), an important technology benchmark, closed above $96.75 on Thursday, which represents a 10% YTD gain -- and a point at which profit-takers emerged late last month.

Not to be forgotten, the Russell 2000 Index (RUT - 1,141.65) -- which has rallied impressively from the round 1,100 area -- still has work to do before taking out 1,163.64, its 2013 close.

QQQ is once again trading in an area that is 10% above its YTD breakeven mark

Daily Chart of QQQ Since May 2014

Turning our discussion back to the VIX briefly, while many standard August equity and index options expired this past week, August expiration for VIX options is this coming Wednesday, Aug. 20. During the past few months, a dizzying amount of call options have expired worthless. In analyzing the VIX's August open interest configuration, a "sweet spot" for VIX settlement on Wednesday morning would be at 13, as a plethora of put and call options would expire worthless, allowing option sellers to pocket the full premium of the options sold.

VIX call sellers -- who are generally selling portfolio insurance to portfolio managers seeking portfolio protection, and who have made a lot of money doing so in recent years -- would welcome a settlement price below 13, as call open interest below this strike is insignificant relative to other strikes above this level.

As it stands now, more than 2 million call contracts will expire on Wednesday morning. Typically, in the days immediately following VIX expiration, the market might be considered most vulnerable to negative headlines. Specifically, many traders are sitting on expired portfolio insurance that isn't renewed right away, and a slow, steady buildup in call open interest in the days after creates market headwinds, as sellers of VIX calls will typically hedge via shorting S&P futures. That said, much of the call volume recently has been rolled from August to option series with expiration dates of September and beyond. Therefore, only about 32% of VIX calls are in the August series, compared to the usual, when front-month call open interest that is about to expire represents about 40-45% of the overall outstanding call open interest.

VIX Open Interest Configuration for the August 20 Series

As we mentioned earlier, there is some round-number resistance overhead on the MID, while the RUT could face resistance from its 2013 year-end close, which is roughly 20 points away from its current price. Meanwhile, the QQQ is back in the vicinity of its July highs, which is 10% above its 2013 close. Moreover, the 1,950 half-century mark on the SPX is back in play, and we have highlighted the importance of these half-century marks in prior reports. Additionally, the SPX 1,960 area could prove challenging to overcome, as it is the site of the index's 40-day moving average, and is roughly a 61.8% Fibonacci retracement of the July peak and this month's low.

The technical levels we pointed out could present speed bumps in the week ahead. However, with the market rallying strongly off its lows, sentiment among short-term traders remains at pessimistic extremes, suggesting there is enough firepower to "deaden" these resistance points. For example, per the second chart below, the equity-only, buy-to-open put/call volume ratio hit its highest level in more than two years this past week, and the weekly survey from the National Association of Active Investment Managers (NAAIM) revealed that this group did not increase their exposure to the market, after a major dumping the week prior. Therefore, bulls can be the potential beneficiaries of buyers who missed the lows last week, and/or short-covering from those positioned for the 10% SPX correction that, to this point, has been avoided, even amid "scary" geopolitical headlines.

Horizontal lines at SPX half-century marks (1,750, 1,850, and 1,950)

Daily Chart of SPX Since January 2014 With 40-Day Moving Average

Equity option buyers are extremely negative on individual stocks

10-day, equity-only, buy-to-open put/call volume ratio with SPX Since January 2013

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