The S&P Trendline That Could Signal the Market's Next Move

A break of key support -- in the S&P 500 Index (SPX), especially -- could lead to extended weakness in the market

Senior Vice President of Research
Aug 31, 2015 at 9:25 AM
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“… [B]ig put open interest below the market can impact expiration-week trading in one of two ways: 1) Act as a magnet (the bigger the open interest, the bigger the potential magnet); or 2) Create buying, as those who sold the puts unwind short positions that are hedges, as the puts are getting ready to expire ... 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

“… [I]n our Friday note we forecasted end-of-the-day selling pressure due to option gamma hedging. We saw similar price impacts on Thursday, Friday, and Monday (pushing the market lower into the close) and an upside squeeze on Wednesday. Our estimate is that up to 20% of market volume was driven by hedging of various derivative exposures such as options, dynamic delta hedging programs, levered ETF stop loss orders, and other related products and strategies …”
-- Marko Kolanovic, Ph.D, Head Quantitative Analyst, J.P. Morgan Securities, August 27, 2015

“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 ... [T]he expiration of August CBOE Volatility Index (VIX - 28.03) futures options on Wednesday morning may have also contributed to the big decline ... 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.”
-- Monday Morning Outlook, August 24, 2015


As you might suspect, the discussion in the middle excerpt above struck a chord with me, as this is the very subject matter that I attempt each and every standard expiration week. And as I mentioned going into August expiration week back on Aug. 17, hedging related to options positions that are about to expire can exaggerate downside moves (first excerpt above), sending the market below anticipated support areas. And finally, as I said last week (third excerpt above), in instances when this occurs, one should expect the market to right itself quickly. If it isn't able to bounce back quickly, the break of support is likely to signal more trouble in the weeks and months ahead.

Monday’s 1,000-point drop in the Dow Jones Industrial Average (DJIA - 16,643.01) isn’t exactly what I had in mind, but the J.P. Morgan analyst quoted above mentioned that technical selling in illiquid pre-market trading tripped hedging-related programs, causing “Flash Crash 2.0” at the open. Whether this is true or not, by week’s end -- despite a nasty Monday morning opening and an ugly last-hour sell-off on Tuesday -- stocks rebounded, with the S&P 500 Index (SPX - 1,988.87) finishing the week in positive territory.

“In a sign the Dow’s nearly 1,100-point swoon Monday spooked investors, stock funds saw $19 billion in outflows on Tuesday -- the second-largest daily redemption since 2007, according to Bank of America Merrill Lynch … [W]eekly flows show $29.5 billion in outflows from equity funds -- the largest outflows on record, based on data collection that began in 2002, the BofA report showed … cash was king, with $22 billion in outflows in the past week.”
-- USA Today, August 28, 2015

The bottom line is that one should be careful about putting too much “stock” into the break of anticipated support when driven in part by derivatives hedging activity. Such failures are often violent and scary, yet temporary in nature. Nonetheless, it has a tendency to generate panic among investors, who yanked money out of equity funds just ahead of a monstrous two-day rally that pushed some equity benchmarks above their previous week’s close.



That being said, one should not be so careless as to ignore the fact that the break of support could be a sign of technical deterioration in the market that is signaling longer-term weakness, or a market vulnerable to retesting previous lows after snap-back rallies, like we saw Wednesday and Thursday. Therefore, a portfolio hedge using index or exchange-traded fund (ETF) put options is one action you can take if you cannot bear the increased volatility and apparent risks that emerged during the past couple of weeks, whether those risks are fundamental or technical related.

Depending what you are anchoring to, index and equity ETF options could be viewed as reasonably priced, using the CBOE Market Volatility Index (VIX - 26.05) as a benchmark. The VIX is calculated using the implied volatility of certain SPX options. It is currently in line with its 20-day historical volatility of 27.36 and almost 50% below last week’s 53.29 peak -- a high not seen since the financial crisis several years ago.

Some of you may be looking for this pullback as an opportune time to commit new money to the market. But, unless you got back in at last Tuesday’s close, when many retail folks were selling, it might be worthwhile to be patient and look for certain benchmarks to clear potential resistance levels just overhead. Or, as we said last week, look for the VIX to move back below 23.90, which is double this year’s low:


“… [A] close above 2,000 would put the SPX back above its 20-month moving average, which is currently around 1,990 ... [T]his 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.”


As we mentioned last week, bulls would like to see a close above the 1,990-2,000 area, with 2,000 a big round number and the site of major September put open interest. Round numbers have proven pivotal, and 2,000 is also triple the 2009 low. Also, as we discussed last week, the significant long-term 20-month moving average is sitting around 1,990, with the SPX in this vicinity as we approach the end of the month today. It will be important for the SPX to close the month either above or very close to this trendline, or the risk increases that we could be looking at a lengthier sell-off that pushes the SPX more than 20% below this year’s highs.

In addition to closes well below this moving average in 2000 and 2008 being followed by prolonged sell-offs, closes below this trendline in May 1977, September 1981, October 1987, and August 1990 preceded either: 1) Two to three months of additional weakness (October 1987 and August 1990); or 2) Longer-term declines over several months (May 1977 and September 1981).

However, in October 1978 and September 2011, closes below this trendline were actually nearer to bottoms that occurred within a month. This history suggests that a monthly close below this long-term moving average increases the risk of a prolonged period of weakness and heightens the risk of a short-term move below last week’s lows.

But adding complexity to this discussion is: 1) The possibility that whatever technical deterioration has occurred was driven by temporary factors related to hedging of derivative positions; and 2) The nearer an August close to this long-term moving average, the more ambiguous the potential implications, as the SPX could easily rally back above or decline back below this trendline in just a matter of days.


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Finally, we thought it was important to end on this note: Last week, we mentioned that a difference between the October 2014 bottom and now is that VIX futures players are net short, whereas they were net long volatility at the 2014 bottom. Well, this changed significantly last week. Fresh data indicates VIX futures players are now long VIX futures, in the biggest one-week change that I’ve seen since following this market. 

Again, this isn’t surprising, as VIX call options had expired -- leaving many futures players without hedges, and others forced to buy VIX calls to hedge, creating another expiration week headwind. Thus, short covering of VIX futures likely drove volatility significantly higher last week and created a massive headwind for stocks. With these volatility players wrong when at extremes (extremes defined as being in a large short position or in a small long position, since they are rarely long volatility futures), the odds have increased that a bottom is in when looking at the market from the perspective of how volatility players are positioned.   


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