The 'Unusual Circumstance' That Could Inspire Bulls

"In looking ahead to July standard expiration, which is now only 10 trading days away, put open interest [at the 205 strike] currently exceeds 300,000 contracts. This is unusually large … 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 

July expiration week saw the S&P 500 Index (SPX - 2,126.64) rally 2.4%, as perceived progress with respect to Greece and its European creditors was made. But there is still work to be done, as negotiations for a third bailout have yet to take place. Moreover, China's Shanghai Composite continued to trade above its July 8 lows, as some listings re-opened for trading. 

The SPX "V-bottomed" and rallied to new highs -- a potential scenario that we presented two weeks ago, per the excerpt above. The magnitude of the rally may have been helped along by short covering related to the massive put open interest on the SPDR S&P 500 ETF Trust (SPY - 212.48) that expired on Friday. 

Market technicians may have been caught flat-footed, or worse yet, caught short just ahead of the rally. For example, the rally from the July 8 bottom began after a move below the index's 200-day moving average -- a sell signal for some investors. Moreover, the bearish head-and-shoulders (H&S) pattern that targeted a move down to the SPX's 2,000-2010 area didn't come close to its target objective, and within the blink of an eye, the SPX was back above the "neckline" of this pattern, in the 2,070-2,075 area. We can't say for certain if those keying in on these technical patterns are back in the market or covered their short positions, but a breakout above the May and June highs would likely invite fresh long positions and induce more short covering. 

Regardless, the area around the SPX's 2014 close continues to act as support on pullbacks, which we have observed multiple times. An interesting scenario would be the SPX pulling back to the 2,070-2,075 area during the next couple of weeks.  If this occurs, it would be a 61.8% Fibonacci retracement of the early July low and last week's high.  If this area was to mark a trough, it would also set the stage for a bullish "inverse" H&S pattern. Given that caution has reigned supreme, we have noticed that bearish H&S patterns have been more recognizable and acted upon than the bullish inverse H&S patterns.

"[D]espite the fact that major indexes in the U.S. recently logged all-time highs, sentiment is negative, which means if 'this too shall pass,' there is serious sideline money and short-covering potential that could drive a major rally by year end."

-- Monday Morning Outlook, July 6, 2015

"The Chicago Board Options Exchange Volatility Index slid 8.5 percent Thursday to 12.11, extending its five-day decline to 39.4 percent … 'The VIX flared up and fell quickly because the world got scared, but this too shall pass,' said Sean Heron, who helps oversee $30 billion for Glenmede Trust Co. 'People are very quick to sell out of decaying volatility. The sellers feel more brazen and the buyers feel more reluctant.'"

-- Bloomberg, July 17, 2015

Short covering directly related to standard July options expiration is over. So, from a short-term perspective, this particular source of demand disappears -- something for bulls to keep in mind as the SPX and SPY attempt to move above their range highs.  In fact, the rally from last week's lows began to fizzle by Thursday afternoon, when these highs were well within reach.  

Also, bear in mind that options on CBOE Volatility Index (VIX - 11.95) July futures expire this Wednesday morning.  With total VIX call open interest approaching 2015 highs and roughly half of VIX call open interest in the July series, those looking to replace expired VIX calls could be active, with August VIX  futures dropping by almost 20% since the July peak. 

The situation with Greece and its creditors could continue to spark volatility spikes -- and one should not be surprised if volatility at least creeps higher in the coming days, with the VIX in the vicinity of its 2015 lows and investors who use equity index and exchange-traded fund (ETF) put options looking to replace expired portfolio insurance.

The good news is that even the short position on VIX futures is not nearly as big now as it was last month, when the Greece drama began unfolding. This positioning reduces the risk of a volatility pop like we saw earlier this month.  Moreover, VIX call buying that is used as a hedge to a short VIX futures position may slow relative to what we have seen recently. 

Weekly Commitment of Traders report -- VIX futures players added to short positions after short covering occurred, but net short position not nearly as big as last month  

 Amid a couple of obvious risks (a VIX pop from low levels and SPX trading at chart resistance), the sentiment backdrop continues to be supportive of a breakout to new highs. One sentiment indicator familiar to loyal readers of our Monday Morning Outlook is a measure of put buying on equities (downside bets) relative to call buying (upside bets).  As you can see on the graph below, the ratio of put buying to call buying is in the early stages of rolling over from an extremely high level, which is consistent with a bullish environment for stocks.

But what about the low VIX? Our buy-to-open data on equity options goes back to 2008 and, unfortunately, there has been only one other instance when the VIX was within 10% of its 52-week low simultaneous with the 10-day, buy-to-open put/call volume ratio within 10% of its 52-week high.  This unusual circumstance occurred last Thursday for the first time since early May 2014. Per the table below, the SPX rallied impressively during the next two months after the first such signal -- but admittedly, this one data point is far from a healthy sample size.

Over the short term, we could see some congestion around current levels or a pullback to SPX support in the 2,070-2,075 area. Continue to view pullbacks as buying opportunities, as this is the trade that has continued to work -- even though we continue to see fear spike as if the "Big One" is coming.