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Critical Zones for the SPY and VIX This Week

SPDR S&P 500 ETF Trust (SPY) put open interest will come into play ahead of options expiration on Friday

Senior Vice President of Research
May 9, 2016 at 9:37 AM
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"With the potential for sideways action in the equities market the next several weeks, and large speculator volatility futures players positioned in such a way that heightens the risk of a volatility surge, now might be a time to use short-term equity advances to lighten exposure and increase exposure in gold."

-- Monday Morning Outlook, May 2, 2016

With the expiration of standard May options only 10 trading days away, we enter the period in which the market could be influenced more than usual by outstanding option positions, particularly when trading around heavy open interest put strikes, which have a tendency to build up due to both hedging and speculative activity.

Above said, the SPDR S&P 500 ETF Trust (SPY - 205.70) broke below the two put-heavy strikes last week, and made its way down to the put-heavy 204 strike, which is where the last significant put open interest is located, before heavy put open interest at the 200 strike comes into play. In fact, given that Friday's lows occurred in the $204 area, it might be argued that this strike acted as a magnet late last week. Bulls can be thankful that put open interest was not heavy at strikes immediately below the 204 strike, as they may have drawn the SPY lower.

We will be paying close attention to the location of SPY put adds in the following week to assess downside risks from an option-related perspective as we move closer to May expiration. For now, Friday's low around the 204 strike could be a floor in the weeks ahead. And, if the SPY can find a base above the 205 strike, short covering related to the heavy put open interest at this strike could be a tailwind as we draw closer to standard May expiration.

SPY open interest configuration

Not only is the 204 strike home to the last significant put open interest before the 200 strike, note that $203.87 represents the SPY's year-to-date (YTD) breakeven level, which is also in the vicinity of its 50-day moving average, a trendline heavily followed by market technicians. Additionally, as you can see on the SPY's one-year chart below, the $204 level acted as support in early July 2015 and early last month. Moreover, breaks of this level last year led to immediate or eventual violent sell-offs, reinforcing the importance of the SPY's $204 zone, equivalent to S&P 500 Index (SPX - 2,057.14) 2,040. Note that 2,040 is only 10 points below the half-century mark of SPX 2,050, and these half-century marks have proven pivotal historically.

SPY daily chart with moving averages

Therefore, the $204 zone is an area that we will be watching closely in the weeks ahead if the pullback in the equity market continues, as a large "risk off" mentality could easily set in motion a move below this combination of put open interest and chart support that we discussed above. If a breakdown occurs, the 200 put strike could eventually act as a magnet. In other words, a chart breakdown might induce heavy selling, and if the selling is heavy enough, the 200 put strike could become a magnet if such a breakdown occurs before standard May expiration.

"… note how the CBOE Market Volatility Index (VIX - 15.89) has advanced comfortably above the 14.07 area, half its 2016 closing high of 28.14. This increases the risk of a volatility rally, which would likely be coincident with a market decline … With the VIX finding support around half its closing high in 2016, and VIX futures players aggressively moving into a hefty net short position in recent weeks, the risk of a market pullback sometime during the next few months has increased … There is a slight glimmer of hope for bulls with respect to the VIX potentially topping last week. The VIX's intraday 2016 high is 32.09. So, bulls can take some comfort that after the VIX advanced well above 16.05 (the half intraday 2016 high) in Friday's trading, it closed below this level. In fact, there were two prior failures to close above 16.05 earlier in April."

-- Monday Morning Outlook, May 2, 2016

As we head into next week's trading, the bulls might find last week’s behavior in the CBOE Market Volatility Index (VIX - 14.72) somewhat encouraging, although they would prefer to see the VIX back below half its 2016 closing high at 14.07 to breathe a little easier.

Note on the chart immediately below that through Friday's session, there were six consecutive intraday moves above 16.05, which is half the VIX’s 2016 intraday high. But on all occasions, the VIX closed at or below this critical level, which also acted as resistance in the first half of April. So, risk of an additional volatility pop is still in play, especially with historically "wrong-way" positioned large speculators in the Commitment of Trader's report still short volatility futures and the VIX above support from half its 2016 closing high. But bulls are hoping that the VIX's 2016 half-high continues to act as a cap in the immediate days ahead.

VIX daily chart 30 days May 6

A close above 16.05 would likely signal, or be coincident with, a break of SPY support discussed above. Given the current positioning of large speculators on VIX futures, either a SPY break of support and/or a close above VIX 16.05 would be worrisome for bulls.

A potential scenario is the SPY entering a short-term choppy, directionless phase, in which the VIX finds itself swinging between the 14 and 16 levels. Such a scenario would make selling option premium, or concentrating on extremely short-term option-buying trades, attractive.

With multiple indices coincidentally rallying to key round-number areas into the late-April Federal Open Market Committee (FOMC) meeting, and subsequently selling off, plus the Russell 2000 Index (RUT - 1,114.77) pulling back from its 2015 breakeven point, one has to wonder if simple technical levels will define support and resistance in the weeks ahead.

For example, the RUT's low on Friday was at 1,101, just one point above the round 1,100 level. And this was coincident with the SPX low at 2,039.45, just below its 2015 close at 2,043.94, before rallying back to close above its half-century mark at 2,050. With the next Fed meeting in June and the market essentially trading where it was when earnings season began, one could argue that a sideways market in the weeks ahead is a growing possibility.

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