Was That Another Big Bear Trap?

A breach of the SPY's 36-month moving average could signal more downside ahead

Senior Vice President of Research
Jan 25, 2016 at 10:11 AM
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"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 … 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 … 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…"
-- Monday Morning Outlook, January 19, 2016

Last week reminded us of August's post-expiration action, following what appeared to be delta-hedging sell-offs during both August and January expiration weeks. Like August, we saw a big sell-off -- literally within days of expiration -- through technical support areas, as momentum sellers piled in, perhaps at precisely the wrong moment.

In August, the technical breakdown below anticipated support (calendar-year low) proved to be a major bear trap. It remains to be seen if last week’s intraday drop below potential support (2015 low) proves to be the second major bear trap in five months.

Regardless, as we suspected, the breach of last year's SPDR S&P 500 ETF Trust (SPY - 190.52) closing low at $187.27 last Wednesday morning led to a sharp, quick move that same day, to just below 2015's intraday low of $182.40. After a brief move below 2015's lows, stocks quickly recovered -- and, by Friday morning, SPY had registered a weekly gain. 

SPY intraday last week – head-fake bear move below 2015 lows?


"… 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 monthly close back above it set the stage for an impressive rally… 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."
-- Monday Morning OutlookJanuary 19, 2016

Last week, we also discussed the SPY’s 36-month (three-year) moving average, currently situated around the 190 strike. As we move into this week's trading following an advance from the 2014-2015 lows (horizontal line in below graph), we are at an important juncture. A monthly close above this trendline would likely indicate that we are only in the throes of another correction, with a potential run to previous highs a strong possibility in the months ahead. But a close significantly below this moving average would likely indicate increasing risk that the 2014-2015 lows will be taken out.

The strong rebound from Wednesday’s low put the SPY closer to the three-year moving average that acted as support on a monthly closing basis in 2011. The jury is still out as to whether this will again hold at month-end this week, but for bulls it is looking better than last week.


Moreover, there is significant put open interest at the aforementioned 190 strike in the February standard expiration series. While we are still weeks away from February expiration, something to think about is if the SPY manages to rally above 190, there is the potential for short covering to occur in step with February expiration. 

Also, whereas we observed SPY peak call open interest strikes in November, December, and January standard expirations that equaled or exceeded peak put open interest strikes, currently, peak put open interest now towers above peak open interest call strikes. The February open interest configuration is more encouraging for bulls, leaving the door open for at least a short-term bounce to the call-heavy 193 strike, with the close above the put-heavy 190 strike on Friday.  


As we said last week, potential resistance from the important 80-week moving average sits at 203.60. This trendline acted as resistance on the initial liftoff from the fall lows. Moreover, the two-year moving average, which acted as support on a pullback in 2012, sits at the round 200 area. There is room to rally, but also a lot of potential technical resistance overhead if a meaningful rally occurs.

One of the more fascinating exchange-traded fund (ETF) charts -- which in fact drove a short-term call trade in one of our short-term option-buying programs in the middle of last week -- is the PowerShares QQQ Trust (QQQ - 103.77). Per the tweet above, after an intraday move below the $100 century mark that marked support on multiple occasions, big put open interest at strikes below 100 expiring last week and this upcoming week held, before a "beach ball" move back above $100. 

Support was from multiple perspectives, both short-term and long-term:

  1. Year-over-year breakeven
  2. The round -10% year-to-date level
  3. The round $100 century mark
  4. Its two-year moving average, which contained pullbacks in 2011 and 2012

Not to be forgotten, as the QQQ managed to hold and close the week above the important $100 level, the Russell 2000 Index (RUT - 1,020.66) closed the week above the 1,000 millennium mark, after trading as low as 958.48. In fact, the RUT is still officially in "bear market" territory, if you are using Wall Street’s definition of trading 20% or more below the high. We continue to recommend avoiding the small-caps to reduce equity exposure during this period of market turbulence. 


RUT overhead resistance is at 1,036, which is 20% below the June 2015 high. Plus, 1,022 is another important level, which is 10% below its 2015 year-end close and the approximate site of Friday morning's high. With the consensus focused and positioned for a stronger dollar and the negative impact on multi-national, large-cap company earnings, small-cap bulls have got to be extremely disappointed with the lack of rotation into this group and, therefore, we characterize this group as having elevated risk relative to the large-cap stocks.

"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."
-- Monday Morning OutlookJanuary 19, 2016

We are becoming a little more constructive on the short-term sentiment backdrop in the context of multiple indexes holding above support areas last week. For example, the 10-day average of the equity-only, buy-to-open put/call volume ratio surged last week from 0.68 to 0.78, which is closer to the multi-year peak we observed last year. With the market higher last week as this ratio surged, it would be encouraging to see this ratio roll over as a sign that short-term pessimism has peaked. But the risk is being premature and the ratio continuing higher, especially if this occurs in the context of a break below last week's lows on the SPY, QQQ, and RUT. 

Equity option buyers inched closer to the multi-year peak in pessimism we witnessed last year, just as stocks found support last week at former pivot lows and round numbers


With that said, short-term bulls should also be encouraged by the CBOE Volatility Index's (VIX - 22.34) plunge late last week. Internally, our thought was to focus on a move below the 25.60-27.30 area for a green light to bet on a tradeable bounce higher. This area marks double the fourth-quarter 2015 lows and half the 2015 high of 53.29.

Or, if you are looking for more evidence of a VIX January peak being in place, look for February VIX futures to decline below the 23-24 area, site of heavy call open interest. The bet would be that unlike January expiration, when only 57% of VIX calls expired worthless, a much larger percentage of VIX calls will expire worthless on the morning of Feb. 17 expiration.

Finally, per the tweet above, and from a contrarian perspective, lower volatility immediately ahead may be a worthwhile bet, especially since the latest Commitments of Traders (CoT) report shows large speculators just moved into a net long position for the first time since August 2015, when the market was carving out a short-term bottom. Large speculators have been wrong about volatility at key turning points, and a long volatility position is rare and unusual from this crowd.

For longer-term investors, the risk we see is that the consensus is factoring in a recession as a low-probability event, in the wake of poor price action since the summer of last year. In other words, recession risk is not priced into the market. If economic data does not support this thesis, equity markets will have a difficult time making headway in the months ahead, and will likely see another failure to take out previous highs if indeed a short-term rally commences. Therefore, we continue to recommend lower-than-normal equity allocations, by way of avoiding small-cap stocks.

Continue reading:

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