SPY Levels to Watch as Fed Catalyst Looms

A positive reaction to the Fed, like last year, could generate major short covering

Senior Vice President of Research
Dec 14, 2015 at 10:11 AM
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"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.”

-- Monday Morning Outlook, December 7, 2015

It was plunging oil prices and weak world markets that spurred a sell-off last week, with the S&P 500 Index (SPX - 2,012.37) lower by 3.8% -- but small-cap equities, as measured by the iShares Russell 2000 ETF (IWM - 111.91), led the way with a 5% loss on the week. The IWM fell beneath its January 2015 lows in the 114 area, and now the September trough in the 107 area becomes a strong possibility.

If you purchased puts on the IWM to hedge, the good news is they rose in value, with implied volatility on the IWM surging roughly 50%. No, the decline had nothing to do with the Fed -- which we identified as a short-term risk last week -- but nonetheless, an IWM put purchase should have insulated you at least partially from last week's sell-off.

By last week's end, the SPX retreated violently back below its 2014 close, after finding support in this area earlier in the week. Moreover, the SPX broke back below its 20-month moving average, the significance of which we discussed in August and September, when this trendline was last breached.  As we move into the Fed meeting this week, the SPX finds itself just above potential round-number support from the 1,980 January lows and 2,000 millennium area, which marked support in January.  A break of the January lows in August led to an additional 5% decline and a period of heightened volatility.




We have spent a lot of time discussing the similarities between the 2014 and 2015 stock markets. The similarities continue, with stocks falling under the weight of falling oil prices and worries about credit leading junk bonds to sell off sharply. 

But during expiration week of December 2014, stocks "undid" the first half of December weakness -- supported by the Fed, which gave an upbeat assessment of the economy and said that it would be "patient" in regards to raising rates. One might argue that the present technical underpinnings are worse than December 2014, as the SPX did not break below its year-to-date breakeven point in December 2014, nor did it fall below its 10-month and 20-month moving averages, which is true at present. 

With that said, this is the last standard expiration week of the year. Additionally, CBOE Volatility Index (VIX - 24.39) calls expire on Wednesday, just hours before the Fed's decision on interest rates.  

In Friday's trading, note how the VIX shot higher by 26%. In fact, perhaps coincidentally, the high of 25.27 was only about half a point below the December 2014 VIX peak of 25.86. The VIX is now trading in an area that is double the May-August lows.   


Note in the graph immediately below that there is major call open interest at the December VIX futures 20 strike. When December VIX futures pushed through the 20 strike (see second chart below), a sharp move higher occurred.

It is entirely possible that -- with only three trading days before December VIX futures options settlement on Wednesday morning -- the sharp VIX move higher was due to VIX call sellers buying VIX futures and/or selling S&P futures to guard against a further spike in volatility. The push through the 20 strike increased the risk of losing money. For months, call sellers have pocketed the premiums of those buying VIX futures calls for portfolio protection or as hedges to short volatility futures bets.  

December VIX open interest configuration -- responsible for an exaggerated move in volatility on Friday? 



Not to be forgotten, on Friday it was weekly expiration for the SPDR S&P 500 ETF Trust (SPY - 201.88). Plus, as discussed last week, we are well within that "window" in which standard expiration mechanics can also lead to sharp movements in either direction. In this case, the move was obviously lower, perhaps helped in part by the big put open interest in the 12/11 expiration series that just expired AND the big put open interest that expires this coming Friday, specifically at the 205 strikes and below.

On one hand, the good news is that a lot of the shorting activity (related to delta hedging) may have occurred last week -- but it is far from exhausted, with a Fed meeting ahead and the 195 and 200 strikes on the SPY potentially acting as magnets in the week ahead. In fact, 195 would not be out of the realm of possibility, especially with a Fed catalyst in the middle of the week. 

That said, a positive reaction to the Fed, like last year, could be the catalyst that generates a mirror-image rally of the decline that we saw last week. A positive reaction would generate short covering related to the big put open interest that is about to expire. Plus, there is the potential of the call-heavy 210 strike acting as a magnet on the upside, given this open interest was mostly bought to open.

The point is that on the heels of a volatile downside move last week, this upcoming week is setting up for a sharp directional move as well. Longer-term stock investors should keep their portfolio protection hedges in place -- given the Fed uncertainty, the location of SPY in relation to key put and call strikes, and a questionable technical backdrop again -- but there is also heavy short-covering potential.

For short-term traders, be sure to have exposure to both sides of the market.  If you are the aggressive and speculative type, you could short volatility futures or buy shorter-dated VIX futures puts, betting that last week’s volatility pop was helped in part by the mechanics related to expiration of VIX options in the middle of this week.   


Read more:

Indicator of the Week: The Best Stocks for Volatility Traders

The Week Ahead: Will the Fed Finally Hike Rates?


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