The Risk to the 'Easy and Simple' SPY Trade

The SPDR S&P 500 ETF (SPY) has rallied headlong into the top of its two-month range

Senior Vice President of Research
May 31, 2016 at 9:35 AM
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After successfully defending the critical $204 level during May expiration week two weeks ago, the SPDR S&P 500 ETF (SPY - 210.24) rallied to year-long resistance and the top of its two-month range in the $210 area last week. The rally clearly caught SPY weekly option players off guard, as put open interest doubled call open interest going into weekly expiration Friday. Per the 5/27 SPY open interest configuration chart below, as of Friday morning, nearly all of the put open interest expired worthless. Therefore, a portion of last week's rally might be attributed to the unwinding of put positions associated with this put open interest.

But, as you can see in the comparison below of 5/27 and 6/3 weekly expirations, the post-Memorial Day week has a fraction of the open interest relative to last week -- and the open interest is not nearly as skewed to the put side, suggesting the SPY will be less influenced by options in the week ahead. Nonetheless, peak call open interest resides at the 210 strike and happens to be the heaviest open interest strike in the 6/3 series. The last significant call is at the 212 strike, so potential resistance in the upcoming week is between the 210 and 212 strikes. Meanwhile, the peak put strike is at 209 and is a potential floor.

Weekly May 27 and June 3 options expirations

SPY 5/27 Open Interest Configuration -- Big put open interest relative to call open interest; last week's action took put buyers by surprise

SPY May 27 weekly open interest configuration

SPY 6/3 Open Interest Configuration -- Smaller bets, smaller potential impact on trading this holiday-shortened week

SPY June 3 weekly open interest configuration

After the CBOE Volatility Index (VIX - 13.81) closed 17 of 19 sessions between its half 2016 closing high of 14.07 and half its 2016 intraday high at 16.05, the VIX experienced three successive closes below 14.07 for the first time since late April. While the SPY did not coincidentally break out above its range, the VIX could be signaling a breakout above the two-month range between $204 and $210. Should this occur, we would expect a move to at least the May 2015 high in the $213-$214 area. 

A breakout above resistance at $210 would take many by surprise. And the VIX level might be considered surprisingly low ahead of Fed Chair Janet Yellen's appearance in front of the World Affairs Council of Philadelphia on Monday, June 6, a Federal Open Market Committee (FOMC) meeting in mid-June, and the "Brexit" referendum on Thursday, June 23.

That said, volatility may be moving lower as multiple voting FOMC members have prefaced the June FOMC meeting with comments that June is "live" for a potential rate hike. Therefore, with the market factoring in a higher expectation for a rate hike in June or July relative to the beginning of this month, the VIX could be suggesting that there is less potential for a negative monetary surprise in the weeks ahead.

In fact, the graph below shows rather impressive SPY price action, with stocks rallying right after Goldman Sachs downgraded equities to neutral for the next 12 months and amid various voting members of the Fed preparing the market for a rate hike in the not-so-distant future. For what it is worth, when the SPY was trading at $193 in mid-January, J.P. Morgan put out a note saying to "sell stocks on any rally" and RBS put out a note saying "sell everything."  

SPY -- climbing after Goldman Sachs downgraded equities and voting FOMC members prepared the market for rate hikes (Click on the chart to enlarge)

SPY daily chart small

"That lack of enthusiasm for stocks has manifested itself in fund flows, cash levels and options prices. The stock-market's rebound since February has done little to attract money to mutual funds and exchange-traded funds. Investors pulled a net $3.9 billion out of U.S. equity mutual funds and ETFs in the week ended May 18, according to Thomson Reuters Lipper ... Investors have poured money into an ETF designed to rise when stocks fall. Estimated net flows into the ProShares UltraShort S&P 500 ETF, which aims to return two times the inverse of the daily performance of the S&P 500, totaled $979.5 million from Feb. 12 through Friday, according to Morningstar Inc.

"Meanwhile, options that pay out if the S&P 500 surges are significantly cheaper than options that turn a profit if the S&P tumbles. An investor could recently buy 18 S&P 500 call options for the same price as one put option, looking at options that are 10% away from the current level of the S&P 500 that expire in 3 months, according to Macro Risk Advisors."

-- The Wall Street Journal, May 25, 2016

Given much macro uncertainty in the month of June, it would be understandable why many market participants are not expecting a breakout above a resistance level that has been in place for a long time. However, the market is a discounting mechanism, so be open to the fact that a breakout could occur before the resolution of these events.

As we discussed last week and as the excerpt above from The Wall Street Journal describes, there is a plethora of caution among numerous market participants. Therefore, a breakout above resistance would certainly take many by surprise and the market is indeed usually full of surprises to the masses. A breakout could be driven by short covering or sideline money moving into equities. 

The easy and simple trade is to short the SPY at $210. The risk to such a trade is that the more a resistance level is tested, the more "obvious" this resistance is to others, and the more likely you are to get in a crowded short position -- the unwinding of which could be extremely detrimental to you. If you think $210 becomes resistance again and short the SPY, we would advise buying cheap SPY calls to hedge, given the increased risk of entering a crowded position.

Per the chart below, unlike previous instances when the S&P 500 Index (SPX - 2,099.06) was approaching 2,100 (equivalent to SPY 210), the equity-only, buy-to-open put/call volume ratio is declining from an extreme high. Rising stock prices are usually concurrent with this ratio declining from an extreme high, as it is now.

A recent extreme in equity option buyer pessimism -- such pessimism is receding and is supportive of stocks

BTO putcall ratio May 27

Despite lingering uncertainty in the coming months that ranges from the Fed to a potential "Brexit" to the presidential election, the sentiment and technical backdrop warrant a bullish view on the market. If you want to hedge a long portfolio with the SPY at chart resistance, consider the purchase of calls on VIX futures.

As we have observed in the past couple of weeks, our chief concern in making the bullish case is the extreme short position among large speculators on VIX futures, who have historically been wrong just ahead of big directional moves in the VIX. For example, this group moved into a rare net short position around a volatility peak in January, and only recently moved into an extreme short position, after VIX futures had declined substantially from their January and February peaks. If they are wrong yet again in the days ahead, a major VIX pop would be coincidental with sharply lower stock prices. But a blind squirrel finds a nut every once in a while, and the large speculators' nut could be in reach.

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