The January SPY Strikes That Could Pose a Serious Threat

Heavy put open interest strikes could continue to exaggerate downside moves in the stock market

Senior Vice President of Research
Jan 11, 2016 at 9:56 AM
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"S&P futures were indicated trading at around 2,000 in pre-market activity, which is roughly equivalent to the 200 level on the SPDR S&P 500 ETF Trust (SPY - 203.87). We mention this because there is decent put open interest at the 200 strike in January's standard expiration series, which expires in less than two weeks. Standard expiration is early this month, with the first of the month being a Friday. Bulls would like to see this round number hold like it did last month, but if bears retain control, the put-heavy 195 strike could very much be in play by the middle of the month. Moreover, the SPY would be vulnerable to filling an upside gap created on Monday, Oct. 5, when it opened at 196.46, following the previous Friday's pin at 195.00."

-- Monday Morning Outlook, January 4, 2016

Last week, with S&P 500 Index (SPX - 1,922.03) futures indicated significantly lower, and trading down to the significant 2,000 millennium area, we indicated that with an early standard January expiration cycle, it wasn't too early to begin focusing on the SPDR S&P 500 ETF Trust's (SPY - 191.92) open interest configuration for clues as how much additional damage could occur between then and January expiration this coming Friday.

Per the 30-minute chart of the SPY below, it looked like the put-heavy 200 strike was going to hold, with Monday and Tuesday closes above this important level. But a gap below the $200 level on Wednesday morning, followed by a failed retest of $200, resulted in a slow bleed to heavy put open interest in the weekly 1/8 expiration series at the 197 and 198 strikes.

Another gap lower occurred Thursday morning as China devalued the yuan, sparking more concerns about world economic growth. And within 24 hours of the gap below 200, the SPY found itself around the 195 strike. It is quite possible that with January expiration just around the corner, these put-heavy strikes acted as magnets in overnight trading, with the Monday and Thursday gap openings around these respective strike prices last week.

The point being that option mechanics may have again helped exaggerate the reactions to the overnight news in China, especially since, in a couple of instances, the U.S. stock market was lower even as the Chinese market rallied -- and most of the losses occurred in the overnight hours, when sellers of the puts were selling futures to hedge themselves against rising volatility and lower stock prices. In the last two days of the week, there was a lot of noise around the 195 strike, with 200- and 195-strike put sellers on the exchange-traded fund (ETF) likely fully hedged or very close to being fully hedged.

So, once again, heavy put open interest below the market in the days preceding expiration and a negative catalyst acted together to push the market significantly lower -- a scenario that has seemingly emerged more and more the past few months.

With the SPY closing around its 195 strike on Friday, and standard January expiration week this coming Friday, the question is, "Should negative news hit the market overnight this week, are there any more heavy put strikes below the market that could potentially act as a magnet and generate sharp selling, like last week?" Such awareness will give one a feel for the level of overnight risk, especially with the market reacting violently to overnight news of late.

Below is January's open interest configuration. Note the heavy put open interest at the 190 strike. Just as the 195 quickly came into play with the SPY at 200, the big put open interest at the 190 strike suggests this strike could come into play quickly in the event of an overnight negative catalyst. In fact, by late Friday, this strike may have begun to exert its gravitational pull. The open interest configuration is something to keep in mind throughout this week's trading in terms for risk/reward.


Moreover, per the data below from our friends at Trade-Alert, the most active SPY January 15, 2016 expiration options on Friday are listed below. The put volume at the 185 and 188 strikes is of particular interest, as this may add to the open interest already at these strikes. If so, these strikes could become legitimate magnets like the 200, 195, and 190 strikes.


In the absence of a negative catalyst, and as we move into the latter part of the week, the shorts are at risk of a short-covering rally related to the big put open interest that expires at the end of the week. With many unknowns, the best advice is to have exposure to both the short and the long side this week if you are a short-term trader.

With the SPX now comfortably below 2,000, we would expect this level to act as resistance on rallies, as it did in mid-September following the August break of 2,000. Potential support is in the 1,860 area, site of the August 2014 and 2015 lows. The 1,838 area is also a level to watch, as this level is a round 10% below last year's close.

Bulls, therefore, should be on guard, with the SPX also below its 20-month moving average for the second time in five months. This trendline acted as support on pullbacks in the late 1990s and multiple times from 2003-2007, and again in 2010. Breaks of this trendline in early 2000 and in 2008 signaled bear market environments, although a break of this trendline in 2011 did not mark the start of bearish conditions.

That said, bulls would like to see the 1,900 area hold if additional selling occurs, as this is the site of the SPX's three-year, or 36-month, moving average, as denoted on the chart immediately below.


"The biggest area of concern heading into 2016 might be with respect to the underperforming small-cap stocks, as measured by the Russell 2000 Index (RUT - 1,135.89), which closed nearly 6% lower in 2015. Despite the calendar flipping to 2016 and a perceived 'fresh start' for this group, we repeat a theme that we have been advising for weeks -- that being, if you are looking to reduce market exposure, do so in the small-cap names. Or, purchase puts on the iShares Russell 2000 ETF (IWM) as a hedge to your long exposure."

-- Monday Morning Outlook, January 4, 2016

After an extremely weak start to 2016, it was once again the small-caps the led the way, losing nearly 8% on the week, in comparison to the large-cap SPX and its loss of nearly 6%.

The decline last week pushed the Russell 2000 Index (RUT - 1,046.20) to a potential area of support, as it closed just 3 points below its October 2014 closing low and 6 points above the October 2014 intraday low. So, while a technical bounce could occur from this level, it isn't anything you should get overly excited about. A bigger concern is the relative ease with which the 2015 lows were taken out last week. Continue to avoid this area of the market, as the technical backdrop is far from supportive of the optimistic views that some have expressed about this particular group in terms of regaining a leadership position.

Finally, the RUT's 60-month moving average -- which equates to five years, and acted as support for most of 2008 -- sits at the round 1,000 area. Other levels to watch if the 2014 lows break are the area between 1,022 (10% below last year's close) and 1,028 (triple the 2009 low). Essentially, in terms of round numbers, long-term moving averages, and round-number percentages above and below key levels, there is hope for small-cap bulls that technical support isn't far away -- but more pain may have to be endured from Friday's close.


Finally, if you are looking for an extreme in negativity among equity options speculators to mark a short-term "V bottom," which occurred in late August/early September and to a smaller extent in mid-December, you are going to have to keep looking.

A concern is that during this period of market weakness, the 10-day, equity-only, buy-to-open put/call volume ratio has been declining. Usually, the market rallies when this ratio is decreasing -- but instead, the market has sold off amid growing optimism from this group. The ratio experienced a minor uptick this past week, suggesting optimism from this group is fading. But at the same time, this turn in sentiment occurs after the ratio hit a multi-month low, indicative of optimism. In late August/early September, note that this ratio was hitting a multi-year high. So, even though the market has sold off sharply, a risk is optimists becoming pessimists in the weeks ahead -- further pressuring stocks, or resulting in only short-lived, minor rallies.


Proceed with caution, with the technical environment deteriorating, but some of the selling possibly attributable to January expiration approaching and the big put strikes that act as magnets on major indexes and exchange-traded funds. If the market cannot stage a meaningful rebound this week or early next week, when short positions related to the expired puts are unwound, caution levels should be raised further.

Read more: 

Indicator of the Week: Was Monday's Sell-Off a Bad Omen for Stocks?

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