Are We Due for an Early Summer Breakout?

Expectations are currently low, which could provide support should markets break out of their recent trading range

Senior Vice President of Research
May 11, 2015 at 8:46 AM
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"Fortunately for bulls, even if stocks retreat back below round-number levels and last week's lows, there are other areas of potential support just below. For example, 2,059 on the SPX is the site of its 2014 close, as year-to-date breakeven levels have proven to be pivotal ... A potential headwind that we see in the short term resides in the sentiment of short-term traders, who -- as exemplified by action in the options market -- recently hit a seven-month optimistic extreme … That said, we don't expect a deep pullback, as there are a plethora of fund managers sitting on a heavy cash position and waiting to use this cash to buy stocks on a pullback."
-- Monday Morning Outlook, May 4, 2015

As you can see in the 30-minute chart below, the short-term risk that we previously highlighted played out into the middle of last week, as the S&P 500 Index (SPX - 2,116.10) declined back below its prior week's lows, before eventually bottoming 8 points above its 2015 year-to-date (YTD) breakeven point, which is roughly 2,060. As the SPX was carving out its bottom, the Dow Jones Industrial Average (DJIA - 18,191.11) was (again) probing support at its 2014 close in the 17,800 zone, and the lagging Russell 2000 Index (RUT - 1,234.93) eyed the round 1,200 area and its 2014 close. As you can see from the charts below, after these support zones we discussed last week held the pullback, the market rallied strongly as investors responded positively to the April employment number on Friday morning.

SPX -- Broke prior week's low and bottomed just above its YTD breakeven mark


RUT -- Round-number 1,200 and YTD breakeven of 1,204 the area of last week's bottom


After acting as resistance earlier this year, the December 2014 close continues to act as support for the DJIA and the SPDR Dow Jones Industrial Average ETF (DIA)


"Meanwhile, the DJIA has been sold at 10% YoY, while the MID 10% YoY has been bought on pullbacks."
-- Monday Morning Outlook, May 4​

The fact of the matter is that many major market benchmarks remain locked in a trading range. Depending on which benchmark you are observing, support and resistance are at round-number levels -- sell the Nasdaq Composite (COMP - 5,003.55) 5,000 or the DJIA 18,000, buy the RUT 1,200 or the S&P 500 MidCap 400 Index (MID - 1,518.77) 1,500. Meanwhile, YTD breakeven points continue to play pivotal roles (buy DJIA, SPX, and RUT around their respective Dec. 31 closes), sell round year-over-year (YoY) percentage gains (COMP YoY 20% and DJIA positive 10%), or buy round YoY percentage gains (RUT positive 10%, MID positive 10%). 

A piece of good news for bulls from a technical perspective is that given that the market rallied strongly from mid-May into early July last year, levels that represent round-number YoY percentage gains -- and that have capped rallies -- will be ratcheted higher and higher through the end of June (and in the case of the RUT and MID, support from these round YoY percentage gains will slowly move higher as we move through May and June). The implication is that we could be on the verge of observing impressive price action, which would mirror last year. In fact, at the end of June, the 20% YoY gain on the COMP would be 5,290, well above its all-time intraday high of 5,132.

"Markets tumbled on that premise Wednesday after Fed Chair Janet Yellen said stock valuations 'generally are quite high' ... Tim Anderson of MND Partners thinks reality is starting to set in and major averages are due for a larger pullback ... Mr. Anderson says that stocks' continued inability to break out has traders discouraged, thinking that equities won't be able to push through resistance after multiple failed attempts. 'The longer the market goes without breaking out, the more people will question what they own at the current valuations' ... [L]ofty valuations may keep a lid on gains."
-- Wall Street Journal, May 6, 2015
"The IMX dipped to a new two-year low of 4.63 in April as TD Ameritrade clients lowered their exposure to U.S. equity markets."
-- Nicole Sherrod, Director of Trading at TD Ameritrade, May 4, 2015
A breakout above the range would likely catch the crowd off guard, as you might infer from the sentiment-based observations above. If anything, expectations are for a continuance of the range or a break below support. Moreover, a breakout above resistance would certainly go against the "sell in May and go away" that was popular in various media outlets coming into this month.

Options speculators are once again displaying fear on a market pullback, as is evidenced by the sharp spike in the equity-only, buy-to-open put/call volume ratio


Finally, with the first day of May being a Friday -- and as hard as it to believe -- this week marks the expiration of standard options, with May 15 being the third Friday of the month, the earliest standard expiration can occur. Below is the May open interest configuration for the S&P 500 ETF Trust (SPY - 211.62). In the event of a pullback next week, premium sellers may attempt to pin the SPY at the 210 strike, where there is a healthy amount of put and call open interest.

Unfortunately for bulls, with the SPY closing at $208.87 the evening before the release of Friday’s employment data, much of the short covering related to heavy put open interest in the 205 through 209 strikes has likely occurred already, as the deltas -- or sensitivity of these options to the underlying SPY price action -- moved sharply closer to zero on Friday as compared to Thursday. As the delta moves closer to zero, sellers of the puts can unwind short S&P futures positions that are hedges to the sold puts. The good news for bulls is that delta-hedge buying could occur, but the impact of delta-hedge buying from the call open interest is much less than the short covering from the put open interest, given the generally lower levels of call open interest. With the SPX coming into the week at the top of its 2015 range, there could be an attempt in a low-volume market to push the SPY below the call-heavy 211 strike at expiration. Bulls, however, would like to see call open interest at the 214 and 215 strikes act as magnets. This would be the lower-probability scenario, however.

Judging by the SPY's May open interest configuration, it could be an uneventful week, with the biggest open interest strikes that are biased toward calls or puts out of the money by a decent amount. But, the domestic economic calendar is full, and monetary policy decisions are due from the European Central Bank and Bank of China. Such events could be catalysts for market moves unrelated to option expiration. In extreme cases, expiration still has the potential to exaggerate downside or upside moves, but it will have to be a major surprise from a central bank or piece of economic data.



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