The Key VIX Level to Watch as Fear Spikes

August expiration for both standard and CBOE Volatility Index (VIX) options may have helped to spur last week's massive sell-off

Senior Vice President of Research
Aug 24, 2015 at 9:03 AM
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"With the RUT currently below the popular 200-day moving average, the risk is a breakdown below 1,200, in which small-caps take counterparts such as the tech-heavy COMP and larger-cap SPX down a slippery slope ... Adding a bit of complexity to the levels discussed above is August expiration week, as standard options are due to expire this Friday ... Expiration-related buying or selling tends to exaggerate downside or upside movements, creating 'fake out' moves below support or above resistance…"
    -- Monday Morning Outlook, August 17, 2015

In order to look ahead, we should revisit last week's bloodbath. As we noted last Monday, it was a standard expiration week. This is important, as whenever an index is situated just above key put open interest strikes during a standard expiration week, a negative catalyst can exacerbate selling relative to what might occur during non-standard expiration weeks.  

The reasoning is that standard expiration weeks tend to have higher put open interest on index and exchange-traded funds (ETFs) that are purchased as portfolio protection from month to month. As an underlying ETF or index approaches these put-heavy strikes, the seller of the puts is usually forced to hedge his exposure by shorting more and more futures in a process called delta hedging. Moreover, the heavier the put open interest, the more robust the potential shorting activity.

We are revisiting this observation from last week, as we saw multiple reasons among market watchers as to what spurred the selling -- explanations of which ranged from worries about U.S growth after the Fed minutes were released to continued concerns about China’s growth, sharp declines in emerging markets and commodities, and devaluations of currencies in emerging markets.  

But what about the magnitude of the selling -- which drove indices below support levels that we had been focusing on the past few weeks? In other words, the S&P 500 Index (SPX - 1,970.89) fell below its year-to-date breakeven mark at 2,058.90, the Nasdaq Composite (COMP - 4,706.04) dropped below the round 5,000 area, and the Russell 2000 Index (RUT - 1,156.79) breached 1,200, setting up the possibility of a move to 1,115 based on the "head and shoulders" pattern neckline break.

There is the possibility that expiration week -- and the heavy put open interest stacked up just below the market going into last week -- contributed to the heavy selling. Make no mistake about it, those that don't focus on the options market and are purely chartists and/or momentum players likely added to the pain. But, we cannot help but notice how big put open interest strikes indeed acted as magnets after the market gapped lower on Thursday morning.

Below are 30-minute charts on two major exchange-traded funds (ETFs) -- the SPDR S&P 500 ETF Trust (SPY - 197.83) and the iShares Russell 2000 Index ETF (IWM - 115.03) -- with their respective August expiration open interest configurations, as of Friday morning. We provide these as a visual to what we observed last week.


SPY August open interest configuration as of Friday, Aug. 21


IWM August open interest configuration as of Friday, Aug. 21


In our view, the expiration of August CBOE Volatility Index (VIX - 28.03) futures options on Wednesday morning may have also contributed to the big decline and last week's enormous volatility spike. The VIX surged amid heavier-than-normal call volume beginning mid-week -- with the expiration of August VIX options -- leaving the many short VIX futures players exposed to a volatility pop. Those short VIX futures likely rolled expired August VIX call hedges into September and October call options, creating unusually large call demand during the week. Such activity helps drive volatility higher and creates an additional headwind for stocks.

In fact, on Thursday and Friday, the VIX moved above levels that marked 50% and 100% above its 2015 closing low of 11.95. With the Friday close above 23.90 -- double its 2015 low -- the risk is a continued spike in volatility. If you want to bet on lower volatility, it is probably best to wait for a move back below 23.90 before placing such a bet. Also note that sentiment among volatility players is different than October 2014, when VIX futures players were positioned for higher volatility, just as volatility was about to retreat significantly. 

VIX Futures -- Unlike October 2014, many VIX futures players are positioned for lower volatility, which is a risk if they cover


The bottom line -- and as we warned could occur during expiration week -- potential support levels on multiple indices were breached. And per former Los Angeles Times financial columnist Tom Petruno's tweet on Friday, a few major equity benchmarks now sit 10% below their respective peaks. Perhaps the next line of support -- 10% below highs?

How much of last week's selling was related to expiration-week selling? This is a major unknown as we move into this week. Remember, as we stated last week, technicians can easily be drawn into "fake out" moves below support as a result of selling that gets exacerbated during expiration week. IF indeed last week's sell-off had much to do with expiration week mechanics, the market should right itself quickly -- quickly being this week. If it cannot right itself, the significance of the negative sentiment that we've been discussing loses some importance from a bull perspective.

If you are thinking about buying into this decline, consider waiting for the VIX to close below 23.90 and/or the SPX to close above the round 2,000 level. Typically, round numbers have held as support, but this did not pertain to the SPX during expiration week. Plus, we view 2,000 as important because it marks three times the October 2009 low.  

Finally, a close above 2,000 would put the SPX back above its 20-month moving average, which is currently around 1,990. As you can see on the chart below, this long-term moving average has been extremely important, acting as support on multiple pullbacks over the years. There have been intra-month breaks below this trendline, so we do put an emphasis on the monthly close relative to this moving average. With that said, two of the past three monthly closes below this trendline -- November 2000 and January 2008 -- have preceded bear-market environments.


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