How to Hedge Against a November Pullback

With stocks still repeating their 2011 patterns, now is the time to hedge your bets with put options on a lagging sector of the market

Senior Vice President of Research
Oct 26, 2015 at 9:12 AM
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"… 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."
-- Monday Morning Outlook, October 19, 2015

The carbon copy pattern of October 2011 continued last week, with the S&P 500 Index (SPX - 2,075.15) and SPDR S&P 500 ETF Trust (SPY - 207.51) testing their respective 10-day moving averages for the second time in a week, before powerful rallies pushed them above their respective year-to-date (YTD) breakeven marks.

SPY October 2011: Two tests of 10-day moving average within a week, before a powerful rally pushes SPY above its 2010 close late in the month.


SPY October 2015: A near-carbon copy of October 2011. Second test of 10-day moving average within a week, followed by powerful rally back above its 2014 close late in the month.


As we discussed last week, bears are hoping that the 2011 pattern continues, as November 2011 was merciless on the bulls. In fact, the rally back above the previous year's close in 2011 marked a short-term top before a short period of choppy trading, followed by a near-10% decline that occurred over a two-week period, ending on Nov. 23. From the perspective of 2015 continuing to follow 2011's price action, bulls should be on guard for potential instability in the market following the SPX's move back above its 2014 close. Moreover, with the Nasdaq Composite (COMP - 5,031.86) advancing back above the round 5,000 millennium area, some investors might use this as a cue to unload some long positions.

"… while the RUT has rallied off of long-term support, there is potential short-term resistance overhead. Specifically, the 1,165 area could be a hesitation point, with this level: 1) 10% below the 2015 closing high in June; 2) the site of the 50-day moving average; 3) a 38.2% Fibonacci retracement of the June high and late-September low; and 4) the site of its January 2015 closing low."
-- Monday Morning Outlook, October 12, 2015

With the SPX above its 2014 close and the COMP above 5,000, an obvious laggard during the past couple of weeks is the Russell 2000 Index (RUT - 1,166.06), with 1,165 acting as a lid in the short term -- a potential resistance level we alerted you to in our commentary two weeks ago. In fact, the RUT continues to trade below its 2014 close of 1,205.

Therefore, if you are looking to hedge a November pullback, the purchase of iShares Russell 2000 ETF (IWM - 115.85) puts might be a worthwhile consideration -- especially with implied volatility on IWM options now at 17%, which is half 2015's peak implied volatility level of 34% in late August. An implied volatility pop from its half-high would be coincident with a decline in the IWM. That said, should IWM implied volatility move below 17%, this would likely be coincident with the RUT moving above 1,165, thereby strengthening the bullish case. On Oct. 5, the CBOE Volatility Index (VIX - 14.46), an index that measures implied volatilities on SPX options, closed below its 2015 closing half-high of 20.37. The SPX closed at 1,987 on that day, and has rallied over 4% since that date.


IWM implied volatility is now half the August peak -- chart courtesy of Trade-Alert


"During the past few weeks, I have also observed the extremes in negative sentiment -- on par with sentiment conditions that have occurred at major market bottoms."
-- Monday Morning Outlook, October 5, 2015

An IWM put purchase should be considered in the context of having long exposure. As we have been saying for weeks, the sentiment backdrop warrants long exposure, as the negative sentiment extreme we observed in late September and earlier this month appears to have climaxed. Historically, after such a climax in negativity, a powerful sustained rally becomes a strong possibility.

Last week, for example, we discussed the rollover in the buy-to-open put/call volume ratio. This ratio continues to make it way lower from a pessimistic extreme last seen during the financial crisis (see the chart immediately below). This week, the exchanges will update short interest data on individual stocks as of mid-October. We will be looking for signs that an unwinding of pessimism is occurring here, as well, as we would expect short interest on SPX component names to follow the same track as the buy-to-open put/call volume ratio, after short interest on SPX component stocks spiked to a multi-year high in September (see second graph below).     



Read More: 

Indicator of the Week: Implications of the S&P Short Interest Spike

The Week Ahead: Apple Earnings, Fed Decision Set to Hit the Street

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