Why SPY Must Hold Its August Low This Week

How much did delta-hedge selling contribute to last week's SPY sell-off?

Senior Vice President of Research
Jan 19, 2016 at 9:38 AM
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"… option mechanics may have again helped exaggerate the reactions to the overnight news in China … [B]ig put open interest at the 190 strike suggests this strike could come into play quickly in the event of an overnight negative catalyst … 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."
-- Monday Morning Outlook, January 11, 2016

Last week, in our report called "The January SPY Strikes That Could Pose a Serious Threat," we discussed the possibility of heavy put open interest at SPDR S&P 500 ETF Trust (SPY - 187.81) strikes below the market continuing to act as magnets, with expiration imminent and negative news predominant. As it turned out -- and unfortunately for bulls -- the SPY put strikes that we discussed came into play.

Bulls tried to defend the put-heavy 190 strike throughout the week, but Friday's gap lower was too much. Expiration day, in fact, is when gaps like this make the SPY most vulnerable to sharp delta-hedging sell-offs, as put options below the market become even more sensitive than usual to market declines. Therefore, an extra sense of urgency surfaces for market makers to sell S&P 500 Index (SPX - 1,880.33) futures to help offset losses stemming from the put options that they sold to those insuring against a market decline or betting on a market sell-off.

As we said back in August, when the market sold off 5% during expiration week, we cannot be 100% certain how much January expiration contributed to the 7% skid in the SPY. We do know that as expiration nears, sell-offs tend to be exacerbated due to the heavy put open interest on indexes and exchange-traded funds (ETFs) that accumulates over the months as hedges. These heavy put strikes will sometimes become magnets, as we saw the past two weeks.

A hint that some of the selling since the beginning of the year is related to delta-hedge activity were the sharp moves that occurred once a put-heavy strike was breached. Moreover, Friday's plunge to heavy put open interest in the 185-187 strike zone is where the selling finally abated, and this is the site of the last heavy put open interest strikes, when combining open interest expiring this past Friday and in the upcoming weekly 1/22 series. The trough in the 185-187 zone potentially indicates that delta-hedge selling related to January expiration was finally exhausted, relieving some of the pressure.



But, as we also said back in August -- if indeed January expiration week played a major role in the magnitude of this pullback, the market will have to right itself quickly, since any selling related to standard January expiration mechanics is now behind us. In August 2015, selling continued into the Monday immediately following August expiration, as the calendar-year lows of January 2015 were breached that day, generating massive technical selling. But the break of the January 2015 lows proved to be a bear trap for short-term traders, as the SPY did right itself quickly, rallying more than 5% from that Monday's lows in only a three- to four-week period. Bulls are hoping for a repeat of that post-expiration trough with today's trading.


"Finally, the Russell 2000 Index's (RUT) 60-month moving average -- which equates to five years, and acted as support for most of 2008 -- sits at the round 1,000 area … 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."
-- Monday Morning Outlook, January 11, 2016

Ironically, the SPY comes into this week just above a key technical level -- August 2015's closing low at $187.27. The closing low was breached Friday afternoon, but stocks recovered quickly -- possibly indicating a short-term rebound is on the horizon, since selling did not sustain itself throughout the day. But if the SPY finds itself below the August closing low again, it could be a quick move to last year's intraday low at $182.40 -- especially if the Russell 2000 Index (RUT - 1,007.72) and PowerShares QQQ Trust (QQQ - 100.84) break below round-number support, as mentioned in the tweet above.


With a strong tendency for a large majority of CBOE Volatility Index (VIX - 27.02) futures call options to expire worthless -- even during this period of uninspiring price action during the past several months -- one speculative bet you could make is on lower volatility through Wednesday in the immediate days ahead, with January VIX futures options expiring Wednesday morning. If past is prologue, Wednesday's VIX settlement could be below the 20-22 area, leaving many call options to expire worthless -- even after a volatility surge and an eye-opening market pullback just ahead of this mid-week VIX expiration. For what it is worth, January VIX futures climbed as high as 28.45 on Friday and closed at 26.35.


"… 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… a risk is optimists becoming pessimists in the weeks ahead -- further pressuring stocks, or resulting in only short-lived, minor rallies." 
-- Monday Morning Outlook, January 11, 2016

Per the excerpt above and the charts below, not all is pretty. It begins with the technical deterioration in the market. In fact, the SPY closed last week below its 36-month (or three-year) moving average. This trendline was supportive in August 2015. In October 2011, this long-term moving average failed intra-month, but a close back above it set the stage for an impressive rally. Such price action reduces the urge for short covering and, in fact, may encourage shorts to grow bolder.

Bulls hope the SPY closes back above this trendline by month's end -- although resistance from its 80-week moving average at 203.68 might put a lid on a rally attempt, as it did in September. And unlike August 2015, short-term speculators are not at a multi-year extreme in pessimism that marked a short-term bottom in late August.


In fact, the risk we highlighted last week is playing out, with optimists in the equity options market turning into pessimists, which has a coincident negative impact on stocks. If short covering related to the expiration of January puts emerges this week, psychology in this group could shift. This would be a best-case scenario for bulls, as it would likely spark a roll-over in the 10-day equity-only, buy-to-open put/call volume ratio at another lower high.


But longer-term investors should still be concerned that, on a net basis, the market has not made headway since the ratio peaked near the end of the third quarter last year.  One would think that if equity option players have generally been less pessimistic, the market would advance -- but this has not been the case.

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