The SPY Level to Watch Amid Fed, 'Brexit' Hype

A near-term SPY breakout above $210 is not a slam dunk

Senior Vice President of Research
Jun 6, 2016 at 9:45 AM
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"...[I]n the comparison … 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 … Meanwhile, the peak put strike is at 209 and is a potential floor."

-- Monday Morning Outlook, May 31, 2016

The holiday-shortened week, as suspected, did not produce upside for stocks, as there was little in the way of potential short-covering related to expiring put open interest, compared to the week before. And, as we suspected, the put-heavy SPDR S&P 500 ETF Trust (SPY) 209 strike in the weekly June 3 expiration series provided support on pullbacks leading into the employment number. Moreover, even after Friday morning's extremely disappointing employment data, which badly missed expectations, the 209 strike again provided support. The SPY did push above call resistance at the 210 strike during the course of the week, but moves above this strike were immediately greeted by sellers that pushed the SPY back to or below $210, resulting in a narrow trading range in the first days of June.

On a net basis, the SPY hardly did anything last week, as there were no major surprises from the Organization of the Petroleum Exporting Countries (OPEC) and European Central Bank meetings in Vienna. Other equity benchmarks approached and were turned away from round-number resistance areas. Meanwhile, the probability of a June rate hike dropped to 4% by week's end, which is where it was at the beginning of last month. Going into last week's trading, the probability of a rate hike was 30%, after many Fed governors suggested in the second half of May that rate-hike expectations were too low.

SPY 10 minute June 3

We are now entering that two-week window in which stock movements during some months have been influenced more than usual by the big open interest that tends to build on standard expiration options, with standard June expiration looming on Friday, June 17. Ahead of June expiration, Janet Yellen will make an appearance today in front of the World Affairs Council of Philadelphia, and on June 15 we will hear from the Federal Open Market Committee (FOMC), just two days ahead of expiration Friday.

In regards to the SPY, like prior months and unlike January and February, there is little put open interest at strikes immediately below its Friday closing price. This means negative news or small declines are less likely to result in bigger declines, since smaller open interest strikes tend to act less like magnets, relative to strikes with bigger open interest.

Therefore, as long as the SPY holds around current levels, we are less likely to see the sharp, swift, option-related selling that tends to turn heads and leave talking heads scrambling to find an explanation as to why the market behaved in a wild manner. It will likely take a huge overnight negative surprise for the 205 strike to come into play via a gap situation, at which point we become more at risk of delta-hedge selling, as other big put strikes come into play below 205. As it is now, the SPY stands to benefit from delta-hedge buying up to about the 212 level, more so than delta-hedge selling materializing in the coming weeks.

SPY open interest configuration June 3

"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 … 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."

-- Monday Morning Outlook, May 31, 2016

Bigger picture, the SPY has rallied about 5 points since early May, as expectations for a June rate hike have gone full circle, from perceptions of extremely low odds of a rate hike in June, to much higher odds after the release of FOMC minutes and warnings from several Fed governors of imminent rate hikes, to extremely low odds of a rate hike in June by last Friday's close.

And as I suggested last week, the obvious trade on the charts is to short the SPY at $210. I will add that since the SPY has sold off from $210 around FOMC meetings, the urge to short could be even greater. That said, even with the FOMC meeting less than two weeks away, and uncertainty related to the "Brexit" referendum later in the month, the CBOE Volatility Index (VIX - 13.77) seems to be hinting at a breakout above resistance, as it touched multi-week lows even as the SPY was trading lower Friday morning in a knee-jerk reaction to the employment number.

From a chart perspective, and even from the perspective of the VIX being low, calling for a breakout is going out on a limb, as most view a low VIX as a harbinger for higher volatility ahead. But, while indeed lower volatility eventually gives way to higher volatility, we have also found that low volatility can persist much longer than naysayers expect. 

A breakout above the $210 level is not a slam dunk. One risk we have mentioned is the extreme short position among large speculators on volatility futures, who historically have been  "extremely wrong" ahead of major VIX moves.

Another risk, which I observed on Twitter last week, is the pricing of out-of-the-money (OOTM) options on the SPY, with OOTM put implied volatility twice that of similar OOTM call implied volatility. In the few instances since 2009 that OOTM put implieds were at least twice that of OOTM call implieds coincident with the SPY trading around 52-week highs, the market has tended to struggle in the short-term. This could suggest that, contrary to what I said last week, a breakout occurs after the June macro uncertainty is lifted.

So, while I may be premature in the expected timing of a breakout, my parting comments from last week bear repeating: "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."

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