Options Data Offers 2 Bullish Clues for December

Market movers appear to be increasing equity exposure right now, but the Fed still poses a major risk

Senior Vice President of Research
Dec 7, 2015 at 9:37 AM
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As you can see above, it is quite clear what we were observing with respect to levels on different equity benchmarks throughout last week. Aided by a surprise decision by the European Central Bank (ECB) to implement less stimulus than expected, stocks sold off from the resistance levels we observed early last week. Most notable was the Russell 2000 Index (RUT - 1,183.40), which was trying to take out the round 1,200 level and its 2014 close at 1,205 ahead of this ECB negative surprise. Not to be forgotten, the S&P 500 Index (SPX - 2,091.69) sold off from that pesky round 2,100 area that has acted as resistance since February, and the Dow Jones Industrial Average (DJIA - 17,847.63) declined sharply from resistance at its 2014 close.

But as stocks tumbled into Thursday's close, the SPX and SPDR S&P 500 ETF Trust (SPY - 209.62) found themselves checking back to their respective 2014 closes, which we viewed as potential support. For what it is worth, Thursday's SPY low was also the site of its 40-day moving average and a 61.8% Fibonacci retracement of the most recent highs and lows. Moreover, at Thursday's close, the DJIA found itself at the half-century mark of 17,500, and the RUT declined to October chart resistance at 1,165 (now potential support).

On the heels of strong employment data Friday morning, stocks rebounded sharply, and the DJIA finds itself right back where it was at the beginning of last week, around its 2014 close of 17,823. Moreover, SPY's Friday afternoon high was just below the 210 strike, and the market closed just pennies above the prior week's close of $209.56.

The three charts below give you good visuals as to the importance of the levels discussed above throughout 2015, and as we observed real-time last week.





"… the SPDR S&P 500 ETF's (SPY - 209.31) rejection at the 210 strike, where heavy November call open interest resided (first chart below). The rejection at the 210 strike was likely driven by November option mechanics, as this open interest was mainly seller-generated, according to data that we receive from the exchanges. Without getting into the details as to why, trust that 'capping' action tends to occur when an underlying approaches a call-heavy strike in which the calls are seller-initiated."
-- Monday Morning Outlook, November 23, 2015

It is hard to believe, but we are only two weeks away from the last standard expiration of the year. Therefore, standard December open interest configurations on various equities, indexes, and exchange-traded funds become increasingly important for us in our analysis.

As we discussed just after November expiration, most of the standard November call open interest at the 210 strike was seller-initiated, which results in "capping" action -- particularly around expiration, as buyers of the puts who desire to be "neutral" short more and more of the underlying as the call option moves up to the strike and becomes more sensitive to the movement in the underlying. So, one might attribute option mechanics that occur around expiration as contributing to the resistance that came in at the 210 strike.


Similar to November's open interest configuration, the SPY 210 strike is home to heavy call open interest, per the December open interest configuration chart immediately below. But unlike November's open interest at the 210 strike, the majority of the December 210 strike open interest is buyer-initiated, which means sellers of the call options (market makers), who typically adjust positions to remain neutral, will buy more and more S&P futures as the underlying approaches the 210 strike. Such marginal buying, which was not the case last month, could spur a rally through 210, which proved resistance last month. A breakout could draw in more buyers or more short covering, leading to a move to (or through) new highs by year's end.



"... deep-pocketed market participants, who are likely to buy puts on index or exchange-traded equity funds as a hedge during times of increasing market exposure, appear to be shying away from committing dollars to the market on retests of the highs."
-- Monday Morning Outlook, November 16, 2015

Analysis of the options market also offers us clues as to what the deep-pocketed market participants, such as hedge funds, are doing with their cash. Are they increasing, or decreasing, market exposure? That brings us to another difference we are seeing in December relative to November.

The ratio of bought-to-open (BTO) put volume relative to BTO call volume on key equity benchmarks is rising, indicative of those who have the ability to move the market increasing their equity exposure. This could be through short covering (therefore, fewer calls will be purchased) and/or using cash to build long positions (more puts will be purchased to protect new long positions).

Combined buy-to-open put/call volume ratio is now rising on SPX, SPY, QQQ, and IWM options -- indicative of hedge funds increasing exposure to the market?


When the market traded around its present levels earlier in the year and last month, this ratio was declining. This decline in the ratio was possibly indicative of heavy hitters shorting more stocks and buying more exchange-traded fund (ETF) or index calls than usual to hedge, or reducing long exposure and purchasing fewer ETF and index puts. With the ratio currently rising, it could suggest these market participants are comfortable increasing exposure at these levels, which would be key to a breakout.

The short-term risk is the Federal Reserve. There is a Federal Open Market Committee (FOMC) interest-rate decision in the middle of next week, and like the ECB, the Fed could deal participants a negative surprise -- perhaps by not hiking rates by a quarter point, even after a stronger-than-expected employment number on Friday. Fed Chair Janet Yellen indicated in her congressional testimony last week that she is ready to hike rates, and the ECB is giving the Fed more latitude to raise rates by not doing as much stimulus as expected, creating a huge rally last week in the euro versus the dollar.

If you want to hedge Fed risk, we continue to recommend the purchase of puts on the iShares Russell 2000 ETF (IWM - 117.78), given its underperformance this year, the relatively muted rally on Friday, and the fact that it has had difficulty sustaining a move above: 1) the round $120 level, 2) its 2014 close of $119.62, 3) its 160-day moving average at $119.79, 4) $118.28, which is 10% above its September closing low, and 5) $118.05, which is a 50% retracement of the June high and September low.

Read more:

Indicator of the Week: Is the S&P a Slam Dunk in December?

The Week Ahead: Retail Earnings, Sales Dominate Quiet Data Week

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