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How Macro Events Could Trigger a 'Melt-Up' For the SPY

Macro events like the FOMC interest rate decision and the "Brexit" referendum could trigger a sharp move for the SPY in either direction

Senior Vice President of Research
Jun 13, 2016 at 9:33 AM
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"Global investors have raised their holdings of cash and bonds, citing fears about potential shock waves from a Brexit vote rippling beyond Britain and the increased likelihood of a rise in U.S. interest rates this summer … Fund managers polled by Reuters in the United States, Europe, Britain and Japan raised cash allocations to 6 percent in May, the highest level since January when global equity markets were in free-fall … 'the greatest risk is a Brexit,' said Nadege Dufosse, head of asset allocation at Candriam … Investors are also cautious as the U.S. Federal Reserve is expected to raise interest rates this summer."
-- Reuters, May 27, 2016

"'All these hedge funds have brought their gross exposure down and if we go up to new highs, they'll be forced to put exposure back on,' Stamford, Connecticut-based Azous said by phone. 'The pain is acute. The only way mathematically these long-short funds can catch up to the S&P index is if the stock market crashes -- if it goes up they'll have to buy with more leverage or turn their portfolio upside-down.'"
-- Bloomberg, June 9, 2016

"… a study by risk-modeling firm Axioma Inc. suggesting European stocks could fall by 24 percent in the aftermath. The majority of forecasters see a downturn in the U.K. economy, in the event of Brexit, but do not see a recession."
-- Bloomberg, June 10, 2016  

This week brings the standard expiration of June options, and with it, macro events that the investment community is watching closely. The first event is the Federal Open Market Committee (FOMC) meeting, at which time we will get a decision on interest rates and updated economic projections from Fed officials. After a disappointing May employment report earlier this month and Fed Chair Janet Yellen indicating "sizable" uncertainties, Fed funds futures traders are placing only a 4% probability of a rate hike. Moreover, market participants will be interested in how the May employment number impacted projections for the economy and interest rates going forward. If Fed officials do not lower their economic projections and push back the trajectory of rate hikes, we could see a stronger dollar and weakness in commodity-based stocks.

The referendum on a "Brexit" occurs on June 23, after the standard expiration of June options. Therefore, in the SPDR S&P 500 ETF Trust (SPY - 210.03) open interest configuration chart below, we combined the June 17 and June 24 expirations in an effort to gauge key levels on the SPY in the event that this week's FOMC decision spurs a directional move that is magnified by soon-to-be expiring options. It should also be mentioned that various polls will likely come out suggesting which way voters are leaning on "Brexit," such as an independent poll released Friday that suggested voters are leaning toward leaving the European Union.

SPY 6/17 & 6/24 open interest configuration
SPY open interest june 10

So, even though the 6/24 expiration open interest might be partly driven by hedging or speculative activity with respect to the "Brexit" referendum, open interest in this series could help influence this coming week's market action. Late last year and early this year, we became accustomed to nearing standard expiration week with major indices and exchange-traded funds (ETFs) trading just above heavy put open interest. In more of those instances than bulls would care to admit, big puts below the market acted as magnets, generating sharp selling around expiration week.

Now, given the SPY's recent strength as it probed all-time highs last week, there is heavy call open interest that could act like magnets, if the reaction to macro events is positive -- creating a "melt-up" situation instead of a "meltdown" situation. In the "melt-up" situation, sellers of overhead calls must buy S&P 500 Index (SPX - 2,096.07) futures to hedge if the options become more and more sensitive to changes in the SPY. This process is called delta hedging, and could push the SPY as high as the 216 strike -- at which point there is a serious drop-off in call open interest. In the absence of a major market-moving event, the higher-probability scenario is that the SPY experiences a small headwind into expiration, as long positions related to the overhead call positions are slowly unwound.

Bears are hoping that there is a quick unwinding of the long positions, either related to the FOMC outcome or continued negative rumors and warnings related to "Brexit," and that the 207 put strike comes into play. If 207 breaks, "delta hedge" selling could push the SPY to the 203-204 strikes, in the vicinity of its year-to-date breakeven level at $203.87.

The takeaway is, we know that there is news on the horizon that has the potential to move the market considerably, as put and call strikes with heavy open interest could act as magnets, depending on the reaction to the news flow. In fact, the market is beginning to price in the volatility, as is evident by the behavior in the CBOE Volatility Index (VIX - 17.03), even as the SPX traded higher over a four-day period last week.

For those with a short-term view, keep in mind that there are multiple indices fighting resistance from round-number levels, specifically:
  • Dow Jones Industrial Average (DJIA) - 18,000
  • SPX - 2,100            
  • S&P Mid-Cap 400 Index (MID) - 1,500           
  • Nasdaq Composite (COMP) - 5,000
Given the uncertain outcome to the upcoming macro events, we continue to advise the purchase of short-term VIX calls to protect against your long portfolio. With round numbers looming overhead, the biggest risk we see is the enormous short position among large speculators on VIX futures, who have been wrong ahead of major VIX moves. With the VIX closing above 16.05 on Friday, half its 2016 intraday high and resistance since late March, "VIX pop/stock drop" risk increases.

Large Speculators - Biggest short position in VIX futures since 2013VIX futures june 10

With the short-term risks as outlined above growing, we still think the risk-reward is in favor of the bulls, for those with a longer-term perspective. Anecdotal evidence points toward an extremely cautious fund manager crowd that is raising cash and bidding up out-of-the-money put premiums on ETF options like the SPY, perhaps due to a tremendous urge to hedge against June's macro events.  

When put premiums are this high relative to call premiums, it is usually the result of hedging concurrent with fund managers adding long exposure. It is at this point that the market becomes vulnerable, after deep-pocketed players increased their exposure. Now, it appears, put premiums are higher relative to call premiums due to hedging activity in the absence of an accumulation of stocks. When this uncertainty is removed, such hedges are bound to be unwound, which is supportive of the market.

5% SPY out-of-the-money puts twice as expensive as 5% out-of-the-money callsput call skew june 10

Chart courtesy of

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