Beware of Higher Volatility Ahead

The Fed's domestic and global economic assessment, as well as a stronger dollar, could create the perfect volatility storm

Senior Vice President of Research
Sep 21, 2015 at 10:00 AM
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"With the Fed and a heavy economic calendar during a standard expiration week, reactions to data could be exaggerated ... if the SPX is able to hold above put-heavy strikes into expiration, short covering related to the expiring put open interest at strikes below the market could generate a tailwind for the market."

-- Monday Morning Outlook, September 14, 2015

September's standard expiration week is behind us, and the "flattish" net move was a huge improvement relative to August expiration week, when the S&P 500 Index (SPX - 1,958.03) lost 5.8%. Now, we head into post-September expiration week, which has been rough since 2000 -- with 12 of those 15 weeks ending lower. The average loss during the weeks the SPX finished lower after September expiration was 2.2%, suggesting the probability of heightened short-term volatility, if history is any guide. Last week's overall flat market occurred within the context of sharp moves to both the upside and downside, with the latter occurring late in the week. A pre-Fed and brief post-Fed rally saw the SPX gain about 3% from the prior week's close at its peak, perhaps driven somewhat by short covering related to put open interest below the market that was soon to expire. 
But, a sudden reversal occurred in the SPX 2,020 area, which is equivalent to the SPDR S&P 500 ETF Trust (SPY - 195.45) 202 strike. The reversal point at Thursday's high was interesting, per the tweet above, as it occurred at a 61.8% Fibonacci retracement of the July high and last month's low.

Plus, as noted in the tweet above, the weekly high occurred at a SPY strike in the soon-to-expire September option series, where call open interest exceeded put open interest by a huge margin (up to that point, put open interest exceeded call open interest). With the "call wall" in place, technical selling and the liquidation of long positions related to the overhead calls may have contributed to the sharp declines from the highs, as heavy put strikes acted as magnets -- notably the SPY 195 put strike, per the September open interest configuration graph immediately below.

SPY September expiration (9/18) open interest configuration as of Friday morning -- note the "call wall" that came into play at Thursday's peak in the 202 area, and the heavy 195 put open interest that drew the SPY back by late Friday


The SPY and the SPX closed Thursday (and the week) below their respective round-number levels at 200 and 2,000 -- which is, coincidentally, the site of their 20-month moving averages, the significance of which we discussed two weeks ago.

For investors looking for an entry point on this pullback from the highs earlier in the year, we would recommend focusing on a monthly close above the SPX's 20-month moving average as one hint that the technical environment is improving, amid the extremes in pessimism that we are seeing that usually mark important troughs. But, as of now, the jury is still out as to whether or not last month's break of this trendline is a sign of tougher months ahead, even as the SPX rallied back nearly 7% from last month's closing low to last week's closing high.

SPX 20-month moving average -- tried, but failed, to close above this important long-term moving average last week, and weak seasonality is imminent 150921mmo2

​While on the topic of road maps for important levels, keep an eye on the iShares Russell 2000 ETF (IWM - 115.72), which is an exchange-traded fund (ETF). This ETF peaked last week at 118.89, which is the site of the historically important, long-term 320-day moving average. This trendline is coincidentally situated just below the IWM's 2014 close at $119.62.

With the IWM representing one-tenth of the value of the Russell 2000 Index (RUT - 1,163.35), note the moving average and year-to-date breakeven resistance align closely with the round 1,200 level on the RUT -- a key area of resistance in 2014. The bottom line is, a close above IWM $120 would be another road sign of an improving technical environment, but clearly we are below this resistance area.


"The month-to-date (MTD) breakeven point on the SPX is at 1,972.18. In fact, the September 2014 monthly close was at 1,972.29. Therefore, both MTD and year-over-year (YoY) breakeven levels have come into play as resistance points during the past couple of weeks ... a level we will be watching closely in the days and weeks ahead…"

-- Monday Morning Outlook, September 14, 2015

The SPX's close above 1,972 last Tuesday foreshadowed strong gains the next couple of days. Last week, we observed the potential short-term importance of this level from the perspective of traders and investors keying on month-to-date and year-over-year breakeven levels. The rally above this resistance area proved only temporary, as by week's end, the SPX found itself back below this mark. This is a level that short-term traders should continue to focus on into the end of the month as a potential resistance area, while keeping an eye on resistance levels from a longer-term perspective discussed above.  

From a potential support perspective, short-term traders should focus on the 1,917 area, as this level is 10% below the 2015 closing high, and has marked this month's lows so far.


"Three years ago, the Fed median official projection was for interest rates to be 1% by the end of this year. A year later, that had dropped to .75%. Now, it’s 0.4%. Why? Because even though unemployment has dipped faster than the Fed expected, economic growth consistently has underperformed, in both the U.S. and abroad. Not only has inflation persistently run below the 2% target, it seems to be getting further away."

-- The Wall Street Journal, September 18, 2015 (subscription required)

"…note that the CBOE Volatility Index (VIX - 23.20) had been establishing a floor at 23.90 since the 50-plus peak just a few weeks ago ... bulls would like to see a sustained move below this level, which we think is significant because it is double the 2015 closing low and thus a level that might seem 'expensive' to anyone anchoring on the mid-July closing low of 11.95. An even 'safer' bet for a volatility decline at this point would be a close below 20.37, which is half the recent closing high. A risk for bulls is volatility players anchoring to the recent highs and viewing the 'half high' in the 20-plus area as a cheap way to play a volatility move higher, especially with the market sitting in the middle of a range."

-- Monday Morning Outlook, September 14, 2015

Finally, volatility watchers should be prepared for higher volatility, post-Fed and with the failures at longer-term resistance last week. Last month, I noted to our traders here that I think that investors are looking for economic growth more than they fear a Fed rate hike. I made this comment after noticing that that stocks plummeted as September rate-hike expectations declined throughout June and July, and then rallied when expectations of a September rate hike rose from mid-July into mid-August.

Last week, the Fed downgraded economic projections (strike one, as far as stock participants are concerned with respect to growth prospects), and expressed concern about international developments and the strong dollar (strikes two and three, in terms of creating more uncertainty). Put another way, the stock market's immediate reaction is that the Fed struck out by continuing to downgrade its growth prospects and remaining "data dependent" for what seems like an eternity.  

Above said, the CBOE Volatility Index (VIX - 22.16) experienced a "head fake" move below "half-high" support in the 20 area, before rebounding strongly Thursday afternoon from its July peak. Therefore, with Fed uncertainty and the market failing at the technical levels discussed above, a VIX move back above 23.90 would likely mean higher volatility in the immediate days ahead. In fact, at this point, another yard marker to look for with respect to a more bullish environment for stocks might be a VIX close below 19.20 -- its 2014 close.

So, even though the extremes we are seeing on the sentiment front suggest a low-risk, high-reward for stock investors (for example, VIX futures players remain net long after a small retreat last week), a suspect technical backdrop downgrades this perceived low-risk, high-reward environment. Therefore, we continue to recommend trades and exposure that allow for profit-making opportunities on explosive moves in either direction.


Read More:

Indicator of the Week: How 'Window Dressing' Can Help You Pick Winners

The Week Ahead: Fed Stalkers Circle Yellen, GDP


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