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The Critical Post-'Brexit' Volatility Level to Watch

The 25-26 area on the CBOE Volatility Index (VIX) is of key importance, as it is double the 2015 low and home to major call open interest

Senior Vice President of Research
Jun 27, 2016 at 9:40 AM
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"I am perplexed by the large short position of Large Speculators on VIX futures. The positioning of these speculators is at odds with many others, who have raised cash amid the growing macro uncertainties. Given the potential unwinding of the short VIX futures trade, a 'leave' vote could create a huge volatility surge and thus VIX calls are an excellent hedge to your long portfolio … Less than 25% of the previous week's short positions on VIX futures were covered during last week's volatility surge. This suggests that there is still room for the short volatility trade to be unwound ... [S]hort-term VIX calls remain an attractive portfolio hedge in the event that market participants react unfavorably to the outcome of this overseas event, as continued unwinding of the short volatility trade would result in volatility futures soaring, allowing a VIX call buyer to cash in with hefty profits to offset losses on long portfolios."
--Monday Morning Outlook, June 20, 2016

In the immediate days leading up to the referendum determining whether or not the U.K. would stay in or leave the European Union (EU), polls suggested the vote would be close, but both polls and betting sites suggested a "remain" vote was highly probable. The prospect that uncertainty related to a "Brexit" would be removed sent the S&P 500 Index (SPX - 2,037.41) and the related SPDR S&P 500 ETF (SPY - 203.13) surging, coincident with voters determining the fate of U.K.'s status in the EU.

By Thursday's close -- ahead of the actual overnight results of the "leave" or "stay" referendum, the SPX and SPY were trading again around round-number, year-long resistance at 2,100 and $210, respectively. Whereas Federal Open Market Committee (FOMC) meetings sometimes pulled the plug on the equity party whenever the SPY was trading around $210, it was the surprising "leave" vote that quickly put an end to the equity party, sending volatility expectations -- as measured by the CBOE Volatility Index (VIX - 25.13) -- soaring on Friday morning.  If you have been reading our Monday Morning Outlook commentary the past few weeks, and as seen on excerpts from last week’s commentary, you are likely to recall that with the positioning of wrong-way Large Speculators on VIX futures, we were at higher-than-normal risk of a volatility explosion

We viewed calls on VIX futures as an excellent way to hedge a long equity portfolio. In fact, someone looking to hedge his equity portfolio ahead of "Brexit" could have purchased VIX weekly 6/29 18-strike calls expiring at Monday's close for $1.55, and sold some ahead of the close on Friday for at least $5.00 -- a profit of more than 200%. 

The VIX soared almost 50% from Thursday's close into Friday's close, but met resistance in the area that is double its 2016 lows, per the chart immediately below.  Loyal readers of this commentary are fully aware that the VIX tends to peak 50% or 100% above key lows and, as such, the 25-26 area is one that we view of importance in the immediate days ahead.

Additionally, the 25 strike is home to the last major call open interest strike before another big open interest call strike comes into play at the round 30 level. This reinforces the importance of the 25 area acting as a potential volatility cap in the days ahead.

VIX daily

VIX open interest configuration

But even though the 25 area represents a potential cap, there is more to consider. For example, after the post-"Brexit" volatility explosion, the potential for a "Frexit" (France leaving the EU) and/or other countries leaving the EU have now beset investors. This -- in addition to what exactly the repercussions that the "Brexit" will have on European and world economies -- has left market participants with more uncertainty. With heightened anxiety about what the future holds with respect to the eurozone, a shift in volatility expectations for the future has arrived. Whereas many were betting on a volatility implosion in the days following the referendum, the tone has changed -- and rather quickly.
In fact, the options market on Thursday and Friday painted a clear example of volatility expectations pre- and post-"Brexit." In Thursday's trading, as British citizens were voting, VIX put volume was 26% higher than call volume. Moreover, a look at the overnight open interest changes saw more than double the number of put adds than call adds, as more of the put volume translated into new open interest. But, by late afternoon on Friday, call volume was nearly double put volume -- even with the VIX at its highest level since February.

"… [L]arge speculators have historically been positioned wrongly at major turning points with respect to volatility movement. For example, they moved into a rare net long position in January, near the 2016 VIX futures contract highs, and increased this long position into February, when VIX futures finally peaked barely above the January highs … 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."
--Monday Morning Outlook, May 2, 2016

Unfortunately, it won't be until this coming Friday that we get a clearer view on how Large Speculators on VIX futures reacted to Friday's news. This data is released each Friday, with their positioning as of the previous Wednesday. With last Wednesday being the day before the vote, there was still a huge short position among Large Speculators on volatility futures. Friday's volatility pop likely involved some covering of this short position, but to what extent would be a guess.
If the VIX closes above the 26 level next week, a move to its 2016 calendar-year high in the 30-31 area would not be out of the question, as volatility expectations continue to reset and the last major call strike with significant open interest is tested, per the open interest discussion above.

Turning to the broader market, I found a few things interesting that occurred before the market's official 9:30 a.m. New York opening on Friday, plus the action during the regular trading session:

  1. The SPY traded briefly down to the $200 level about one hour before the 9:30 a.m. ET opening -- site of big put open interest in the combined 6/24 weekly, 6/30 quarterly, and 7/1 weekly options series. As I have stated numerous times, big put strikes can act as magnets in the days preceding expiration. I found it interesting that the big 200 strike marked pre-opening lows.

  2. The 203 put strike has a decent chunk of put open interest, too, before put open interest drops off and the 200 strike comes into play. Note how the SPY found support at the 203 strike during the regular session's trading on Friday, and managed to close above this put-heavy strike. However, it closed slightly below its year-to-date breakeven level of $203.87. 
As we have said before, big put strikes as expiration approaches tend to act as magnets, especially on the heels of a negative catalyst. In this particular case, there were three expirations within a week -- the 6/24 weekly (options of which expired on Friday), the 6/30 quarterly expiration, and the 7/1 weekly options series, which expire on successive days this week. While these were not standard third-Friday-of-the-month options that tend to be heavier than weekly and quarterly options, the combined open interest of these three expiration was big enough to influence Friday's trading.

So, if you were surprised by the magnitude of Friday's decline -- especially after hearing that many fund managers have raised cash levels to extremely high levels -- keep in mind that put open interest on soon-to-expire options may have (again) played a part in the downside volatility we experienced on Friday.  

Also of interest is how Friday's close has marked several buying opportunities this year, as the area of the 2015 close of $203.87 has been supportive since March, when the SPY first moved into the black for 2016. Moreover, per the third chart below, you can see how the 203 put strike is much smaller after the expiration of 6/24 weekly options, which may have been "Brexit" hedges. In other words, put open interest magnets are smaller leading into this week’s "double expiration" that involves quarterly (6/30) and weekly (7/1) options.

To the degree put open interest induced heavier-than-normal selling of S&P futures on Friday, a snap-back rally would be expected. This would imply seeking short-term opportunities on the long side if the VIX remains below 26 and the SPY is above or in the vicinity of its 2015 close at $203.87. If you are one that needs to see the SPY above an even higher level before engaging in a new long position, look for a close above the put-heavy strike, as we have sometimes found put-heavy strikes act as resistance on a retest after a breakdown.  

SPY open interest configuration June 23

SPY daily

SPY June 30 quarterly and July 1 weekly expirations open interest configuration

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