Will Volatility Players Throw a Wrench in the Bulls' Plan?

Although the technical and sentiment backdrops favor the bulls, VIX traders could present a short-term risk

Senior Vice President of Research
Jun 1, 2015 at 8:16 AM
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"A risk to the bullish case, or potential headwind that we see, is the positioning of volatility players, who recently reduced their CBOE Volatility Index (VIX - 12.13) futures short exposure, according to the latest Commitment of Traders (CoT) report. This is occurring with the VIX trading around its calendar-year low. With roughly 40% of outstanding VIX call contracts expiring last week, some of which might be hedges to short VIX futures positions, the urge to cover could grow in the coming days, sending volatility higher and stocks lower."
-- Monday Morning Outlook, May 26, 2015


Despite low expectations among retail investors that have more often than not preceded positive returns during the holiday-shortened Memorial Day trading week, the equity market experienced losses last week. It was Tuesday's action that accounted for the week's losses, as equities actually moved higher from Tuesday's close into Friday's close. Memorial Day week trading has proven hazardous for bulls in recent years, with five of the past six Memorial Day weeks producing negative returns. Bonds managed to rally, and the CBOE Volatility Index (VIX - 13.84) popped on Tuesday, but June VIX futures were barely higher, as volatility expectations remain relatively muted.

Despite the VIX pop and two days of heavy selling, the VIX has not moved above its 80-day moving average, which has capped higher moves in the VIX since March. That said, despite achieving a new calendar-year low the Friday before Memorial Day weekend, the VIX is having trouble sustaining a move below the 11.75 area -- which is half the 2015 high in the 23.50 area.

The good news for bulls coming into this week is that the VIX is trading nearer to resistance than support. This is a switch from the prior week, when the VIX was more vulnerable to a pop, as we briefly discussed last week.

Daily Chart of VIX Since December 2014 With 80-Day Moving Average


"... the DJIA is still getting capped at its 10% YoY return … also of interest is how the COMP is seemingly moving higher from its 20% year-over-year (YoY) return, after dancing around this area for most of this year. Furthermore, the SPX is now using its 10% YoY return as support, after dancing around this level for much of the year. For next week, this would imply support between 2,100 and 2,110 … even if these equity benchmarks continue to hover around their respective round-number YoY percentage returns, the outlook would be 'minimal downside in the immediate term to higher stock prices during the next month,' which presents an attractive risk-reward environment, from this perspective."
-- Monday Morning Outlook, May 26, 2015

Per the chart below, the S&P 500 Index (SPX - 2,107.39) -- the red line -- pulled back last week to a potential area of support that we identified, which represents a roughly 10% year-over-year (YoY) gain in the round 2,100 zone. Meanwhile, the Dow Jones Industrial Average (DJIA - 18,010.68) -- the blue line -- continues to get capped at its 10% YoY return mark. Finally, the Nasdaq Composite (COMP - 5,070.03) -- the yellow line -- due to last year's gains around this time and this year's losses, is again dancing around the 20% YoY gain zone. 


From a technical perspective, as we look ahead to next week, benchmarks such as the DJIA, SPX, and COMP are sitting just above potential support. For example, the DJIA is located just above the round 18,000 level -- after briefly dipping below this important millennium mark on Friday. The SPX is sitting in the area of its 10% YoY gain and the round 2,100 mark. If the SPX rallies, and continues to hover around the 10% YoY return, you would expect to see resistance at 2,135, which is just above this month's highs. Finally, the COMP is situated 70 points north of the round 5,000 level, and only 43 points above the 5,027 level, which is 10% above its 2014 low. And if the COMP continues to hover around its 20% YoY mark, expect gains to be capped at 5,155 at week's end, which would be an all-time high.  

From a macro perspective, there is plenty that can push stocks out of last week's Tuesday-Friday range. The economic calendar is full, with reports on personal income and manufacturing on Monday, factory orders on Tuesday, and employment data on Wednesday and Friday. Moreover, investors will be tuned in closely to developments across the pond, with Greece and eurozone leaders negotiating ahead of a scheduled debt payment by Greece on Friday. Many believe Greece will not be able to make good on this payment, and there is no guarantee that support will be provided unless a deal is reached. 

Most of our sentiment indicators are supportive of stocks -- the buy (to open) equity-only put/call ratio is still descending from highs, and this is usually supportive of equities. Plus, surveys suggest more pessimism than usual. Moreover, even though stocks pulled back last week and are back in their multi-month range, they remain above support levels, implying a bullish technical backdrop.

But, an area of risk that we continue to see is the positioning of volatility players, who added to short VIX futures positions last week -- but stocks failed to catch a strong bid. Now, bets on a decline in volatility among these participants are at the highest level since August 2014, which preceded a VIX spike. And even though the number of short VIX futures positions is on par with August 2014, hedging activity (via VIX call open interest) is not nearly as high at present. The implication is negative news could send short VIX futures traders covering, sending volatility sharply higher and stocks lower. 

The risk identified above, plus the uncertainty related to this week's economic data and the European news, would suggest that you have a hedge -- VIX call or equity index put -- in place to protect long positions as we head into a potentially volatile week.




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