"We'll look at the SPDR S&P 500 ETF Trust (SPY - 201.33) open interest configuration to discuss a possibility for the next week. What stands out is the big put open interest far beneath the current market price. It is possible that the sharpness of the recent rally was helped along by the unwinding of short positions related to this put open interest, as the deltas -- or sensitivity of these options to SPY movement -- decreased as the SPY moved further above the strikes and we moved closer to expiration. This would argue again for a consolidation to the extent that short covering may not be as great. …We would expect to see a decline supported at the 198 strike, where put open interest exceeds call open interest by a wide margin. A rally could find resistance in the 203 area, home to the SPY's 80-day moving average, and where call open interest dwarfs put open interest."
-Monday Morning Outlook, October 12, 2015
The broader market behaved as we expected last week, although with much more daily volatility on Tuesday and Thursday than anticipated. The SPDR S&P 500 ETF Trust (SPY - 203.27) experienced a shallow pullback to its 10-day moving average by the middle of the week, just above the put-heavy 198 strike, before rallying through the prior week’s highs to the call-heavy 203 strike on expiration Friday morning. This strike price is also the site of the mid-September high, which to no huge surprise is where the advance off the Thursday lows slowed.
For what it is worth, the SPY’s 2015 price action continues to follow the pattern of 2011, even down to how it has behaved in October of both years. In other words, following bullish key reversal days in the first week of the month and bull gaps the day after the key reversal, there was a shallow pullback to the 10-day moving average mid-month, from which a rally followed. In 2011, the rally lasted into month-end, at which point the SPY declined by 9.5% into late November. The two charts below give you an excellent visual for the similar SPY patterns we have observed in October 2011 and 2015.
In October 2011, by late month, the SPY was challenging the prior year’s close. It hit this level, pulled back to the 10-day moving average again over a two-day period, but popped above its year-to-date (YTD) breakeven point in the last week of the month. It was only temporary, however, as this marked the beginning of a 9.5% decline into the end of November 2011. If the SPY continues to follow the October 2011 pattern, note that its YTD breakeven mark is at $205.54, which could be short-term resistance if the rally continues.
"Treasury Secretary Jack Lew said Thursday the U.S. debt limit will be exhausted Nov. 3, two days before previously estimated ... Lew also said the U.S. government would not be able to meet most of its obligations without a higher debt ceiling and thus urged Congress to raise it. 'We have learned from the past that failing to act until the last minute can cause serious harm to business and consumer confidence, raise short-term borrowing costs for taxpayers, and negatively impact the credit rating of the United States,' he said."
-CNBC.com, October 15, 2015
If stocks rally into the month-end like October 2011, would that set up the potential for another corrective pattern, like November 2011? Given how 2015 has been a mirror image of 2011, it is certainly a possibility to be seriously considered. In fact, with the cost of portfolio protection -- as measured by the CBOE Volatility Index (VIX - 15.05) -- now more than 50% below its August closing high and roughly 15% below last year’s close, it might be worthwhile to purchase portfolio protection.
Adding to the "worthiness" of portfolio protection, especially if stocks rally further and the cost of portfolio protection decreases more, are Jack Lew’s comments regarding the debt ceiling. In 2011, the U.S. received a credit rating downgrade, a possibility that Lew warned about if Congress cannot come to an agreement. Complicating matters is that a new Speaker of the House remains in question. Moreover, October VIX options expire this coming Wednesday, and VIX pops tend to occur in the days after VIX expiration. In summary, cheaper portfolio protection -- a "known, unknown" relative to the outcome of the debt ceiling -- and the potential of 2015 continuing to behave eerily similar to 2011, could be compelling reasons to have exposure to a volatility pop in your portfolio.
The risks we just outlined are within the context of a recent extreme in negativity that has been consistent with major market bottoms and an improving technical environment, with the VIX below the 19.20-20.37 area that was potentially supportive and the S&P 500 Index (SPX - 2,033.11) rallying back above 2,000 and its 20-month moving average. A monthly close above this trendline would be even more encouraging. The Russell 2000 Index (RUT - 1,162.31) rallied from long-term support at its 40-month moving average last month, which also marked the 2011 bottom, but resistance at 1,165, discussed last week, is presenting a short-term challenge.
"…[A]n encouraging sign is that despite the S&P 500 Index (SPX - 1,951.36) dropping to a Tuesday low of 1,872, just 5 points above the August closing low, the VIX intraday high last week was only 28.33, or 47% below August's VIX intraday high of 53.29. This divergence is something for both bulls and bears to note -- especially in the context of the bear market bottoming phase in early 2009, when the SPX retreated to the October 2008 low, but the VIX high was 40% below the October 2008 VIX peak."
"The build-up in pessimism among equity option speculators is confirmed by higher lows in the put/call volume ratio and higher highs. So, like 2009, one thing to look for with respect to this ratio confirming that a bottom is in (or near) would be a lower high being followed by a lower low. This has not occurred, but it is something that we'll continue to follow closely as we look for clues as to which way the SPX's next big move will be."
-Monday Morning Outlook, October 5, 2015
The behavior of a couple of sentiment indicators suggests that even with the short-term risks discussed above, the worst of the decline occurred in August and September, paving the way for tremendous upside in the event that the pessimism is finally unwound.
Two weeks ago, for example, we discussed the divergence in the VIX -- excerpted above. In September, the SPX bottomed around its August lows, but the VIX peaked far below the previous month’s peak, a pattern that we observed in March 2009.
We also discussed what we were looking for with respect to the behavior of option speculators, who at the time were as negative then as any time since the 2009 market bottom. Specifically, while they were negative, the risk we observed was that such negativity was growing, coincidentally pressuring the market. Our takeaway was that in order for the market to bottom, there had to be evidence that the build-up in negativity had climaxed.
As I pointed out on Twitter last week, the first hint that pessimism had indeed climaxed was the failure of the 10-day equity-only buy-to-open put/call volume ratio to move above its prior high, as it rolled back over earlier this month and is now back below a previous low, reversing a trend of higher highs and higher lows in place since early summer.
For this reason, we recommend long exposure, but also recommend the purchase of cheap portfolio insurance in case the market continues to follow the exact path of 2011.
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