Q2 STOCKS TO BUY

Why Bulls Still Have the Upper Edge

Despite several short-term risks, the market may be poised to rally on unwinding fear

Senior Vice President of Research
Jul 13, 2015 at 8:50 AM
facebook X logo linkedin


"The question moving forward is, 'Will last week's lows be revisited?' ... [T]he bigger the open interest at a put strike, the more likely it is to behave like a giant magnet when price action isn't exactly strong -- which has been the case in recent days … [as] put open interest currently exceeds 300,000 contracts (at the 205 strike) … One scenario is stocks breaking down sharply below support, with the help of big put open interest strikes on key exchange-traded funds and indices acting as 'magnets' -- such as the 200 through 205 strikes on the SPY. The decline might also be helped along by those that focus on the popular 200-day moving average. However, if such a sell-off occurs, it will be short-lived, as various indices put in lows by July expiration at levels in which few investors would anticipate ... [I]t will be key in the weeks ahead for the SPY to remain above the 205 strike, as a break below could lead to accelerated selling that pushes the SPY to the 200 or 202 level. If the SPY can hold 205, we might see short covering into expiration that pushes the SPY back to its recent highs."
-- Monday Morning Outlook, July 6, 2015

Whether last week's action was driven by continued negotiations between Greece and its creditors, or the sharp sell-off and snap-back rally in China, or a temporary New York Stock Exchange (NYSE) closure due to a software upgrade issue, or all of the above, the net result was another week of huge daily volatility that resulted in very little net overall movement.   

Per the excerpt above, we left open the possibility that recent lows would be revisited -- and this indeed occurred, as you can see on the two-week, 30-minute chart of the SPDR S&P 500 ETF Trust (SPY - 207.48) below. In fact, the put-heavy 205 strike indeed acted as a magnet once again, when China's market went into a free-fall and the outlook in Europe appeared grim. For now, the SPY is generally holding support in the area of the 205 strike and its 2014 close at 205.54, which is a plus for the bulls. That said, rallies on what has been perceived as positive news have been capped in the 207-208 area, which marked lows in May and the first half of June.

150710mmo1

Today begins expiration week of July standard options, and the outlook remains the same as the past couple of weeks. Specifically, heavy put open interest below the market on key index and exchange-traded funds could exaggerate short-term moves. Moreover, the market's direction will likely depend on whether or not China's market can sustain the late-week gains -- or, at least, halt its deep slide -- after its government stepped in to stem the sharp sell-off, and/or how our market reacts to news that is expected out of Europe over the weekend. But that isn't all. Fed Chair Janet Yellen is scheduled to deliver her semi-annual testimony in the middle of the week, central bank decisions in Japan and China are on the calendar, and earnings from major banks will be released. 

Side note: In a speech in Cleveland on Friday, Yellen indicated there will likely be a rate hike in 2015. The market took this in stride, suggesting a hike is factored into the market.

In what is expected to be a week with a heavy dose of market-moving news flow, we would not be surprised to see gap openings and major intraday swings, much like we've been accustomed to during the past couple of weeks. If negative news is predominant, selling -- exaggerated by option mechanics during expiration week -- could drive indexes down to heavy put open interest strikes in the 202-205 area on the SPY, which means key support levels would temporarily be broken. However, positive news would generate heavier-than-normal short covering, related to the expiration of the heavy put open interest that we have been pointing out to you.

SPY July Open Interest Configuration

150710mmo2

 


From a technical perspective, and as discussed above, bulls still have the upper edge as the SPY trades above multi-tiered support from a combination of round-number percentage gains, relative to significant highs and lows in the past (see my Friday tweet above) -- specifically, its year-to-date breakeven zone and the put-heavy 205 strike. 

Moreover, while we have observed that buyers of volatility have emerged at 15.50, which was formerly a "sell volatility" zone, it has become evident in recent days that sellers of volatility are now emerging when the CBOE Volatility Index (VIX - 16.83) moves into its year-to-date breakeven zone around 19.20. There were two closes above this level last week, but this was immediately followed by a gap lower. Those selling index and exchange-traded fund puts (volatility sellers) create a tailwind for the market, whereas buyers of index puts (volatility buyers) generate a market headwind. A decisive break above 19.20 or below 15.50 will likely hint at the direction of the market's next major move. For now, it has been a volatile range during the past two weeks as the VIX bounces around these key levels. 

150710mmo3b



The S&P 500 Index's (SPX - 2,076.62) June peak to last week's low was roughly 4%. But since mid-June, the extreme in net short positions on VIX futures has been cut by more than half, suggesting that complacency among volatility players has been reduced significantly. Furthermore, something that has really caught our eye is the sentiment among equity option speculators. 

For example, note how the 10-day moving average of the equity-only, buy-to-open put/call volume ratio has spiked up to the level that marked a bottom in October 2014. With puts being bearish bets and calls being bullish bets, this ratio is a measure of sentiment. The higher the ratio, the more fear among option speculators. The current spike in fear has occurred amid a backdrop of a 4% decline at last Tuesday's lows. This is a mild decline relative to the 9.8% decline that inspired such anxiety and marked a "V-bottom" last fall.

Even though the short-term continues to present risks to the bull case, the sentiment backdrop is one in which bears should be careful, as an unwind of this fear is capable of producing a double-digit rally in a short period, just like we saw in October-November last year. 

 150710mmo4

 

 
 

“Buy This Stock Now!” - Expert Who Called 11x On TSLA

He called a rare 11x on Tesla…

But now, thanks to Elon & Trump’s new alliance…

He says there’s a new opportunity that could be 1,000x BIGGER than Tesla – and it could completely revolutionize a $23 Trillion market.

It’s trading for less than $5 per share right now…

But it won’t be under the radar for long.

Discover The 1,000x Bigger Elon Opportunity Here

GRAND SLAM COUNTDOWN

 
 

Featured Articles from Trusted Partners:

👀Learn How Dividends Create Passive Income for Life
Receive $200 Off Motley Fool Epic. The Motley Fool Epic $299 discounted offer is based on $499/year list price. Introductory promotion for new members only. Take control of your money and your portfolio with Motley Fool Epic.

💵New Income System Could Pay You $4,243 Monthly
You could collect an average of $4,243 per month starting as early as next week with a new payout system for income investors. New registrations are being accepted for investors who want to be in a position to start with their first payout next week.

🚀Easy 92% Crypto Dividends (No Coins Required)
COIN stock doesn't pay a dividend... But there's actually a new way to collect a massive dividend that's indirectly based on the stock and offers a terrific monthly income (currently yielding nearly 92% on a forward basis).

🤝Free Advisor Match with Wiseradvisor.com
Don't leave your retirement to chance! Get matched with a trusted financial expert for FREE and make the most of your tax refund. Get started now.

⚠️Dennis Quaid's #1 Warning for Americans
Here's the thing: life doesn't come with guarantees. The economy shifts, markets stumble, and years of hard work could slip through your fingers like sand. But it doesn't have to be that way for you. So request a free copy of this Gold & Silver Guide that will arrive right to your doorstep when you act now.

 

 
 

Follow us on X, Follow us on Twitter