Exposing the Stock Market's Short-Term Vulnerabilities

Heavy call open interest could serve as a speed bump for SPY in the weeks ahead

Senior Vice President of Research
Aug 8, 2016 at 9:57 AM
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Much was made last week over the fact that the Dow Jones Industrial Average (DJIA - 18,543.53) completed a seventh consecutive daily decline.  As you can see in the table below, a losing streak of this duration has occurred 54 times in the past. What was remarkable about this streak, relative to the past, was the Dow lost only 1.4% over those seven days -- the smallest percentage decline of the 54 prior occurrences. For perspective, nearly 70% of losing streaks of seven days have produced losses of 4% or more.  

There is not much historically to go on when a small decline occurs within the context of a seven-day losing streak. However, for those of you who are curious to see how the DJIA behaved in previous seven-day losing streaks, broken down by percentage declines, we produced the table below for you.

Dow Returns After Seven Day Losing Streak

Beyond this streak and all of the attention it grabbed, what impressed us is that after taking out its 2015 all-time highs last month, the Dow's losing streak ended at the site of its 2015 highs -- former resistance. Moreover, the Dow didn't come close to losing the 18,000 millennium level, which acted as resistance from November through early July.  

Friday’s better-than-expected employment data pushed the Dow higher from last year's resistance. And heading into the typically weak August and September months, the DJIA has two short-term resistance levels to overtake in the days ahead. The first is its July all-time closing high at 18,595. If that level is overtaken, the next level that would come into focus is roughly 200 points overhead at 18,800, which is a round number that is 20% above the August 2015 and February 2016 closing lows.

Dow daily chart since Feb 2015

"[A] benchmark that has continued to follow through with sharp gains that began in late June is the Nasdaq Composite (COMP - 5,162.13), thanks to positive earnings reactions …There is work to be done, as 5,231.95 represents the COMP's all-time high in July 2015. With 5,007 -- its YTD breakeven level -- situated just above the round 5,000 millennium, we figure this to be a strong area of support in the event that this benchmark cools in the days ahead."

-- Monday Morning Outlook, August 1, 2016

Not all equity benchmarks experienced a seven-day consecutive losing streak like the Dow. In fact, the Nasdaq Composite (COMP - 5,221.12) continued on with its hot ways, closing lower only once during the DJIA's losing streak. The low on the day that decline occurred was in the 5,100 area, site of the COMP’s year-over-year breakeven level and the late-December 2015 closing high that preceded a 16% decline into early February 2016.  With support in the 5,000-5,100 zone, the COMP comes into this week trading just below its 2015 all-time high at 5,231.94, which could present a temporary roadblock in a longer-term anticipated move higher.

Finally, the SPDR S&P 500 ETF Trust (SPY - 218.18) -- after trading in a tight range for several days -- made a bold move to all-time highs after the release of the July employment report. Prior to this breakout, the SPY had been experiencing resistance 20% above its 52-week low at $217.30.   

On the day before Friday's breakout, the SPY's low at $214.25 was the site of double its five-year low. The $218.50 level on the SPY could present the next short-term speed bump, as this level is 10% above the late-June low.   

SPY daily since June 2016

Additionally, as we enter the two-week window that precedes standard August options expiration, the market's short-term movements are more vulnerable to being influenced by the large number of outstanding option contracts that have accumulated at various strike prices.  

Note that in the expiring weekly August 12 and standard monthly August series that quite a bit of call open interest has built up at the SPY 218.50 strike. This strike boasts over 220,000 contracts in open interest, and is the second-largest strike in the vicinity of Friday's SPY close. The point is that the 218.50 level could be significant in the immediate days ahead as traders locking in 10% profits from the late-June low -- plus an attempt to keep the SPY below a major call open interest strike by those selling the calls at this strike -- represent a potential short-term headwind.  

SPY August open interest confuguration

A move above $218.50 would likely lead to a test of the call-heavy 220 strike. A majority of the calls at the 220 strike were bought to open when the SPY was at $208, so those who sold the calls to the opening buyers likely hedged very little at that time. If the SPY approaches $220, increased hedging via the purchase of S&P futures may become necessary, generating a sharp (delta-hedge) spike up to -- and possibly through -- the 220 strike.   

In other words, just as big put strikes immediately below the market are more apt to become magnets during periods of market weakness around expiration, the same is true for big open interest call strikes immediately above the market when the market is exhibiting strength around expiration.

The downside to this is that the longer the SPY remains below $218.50, a potential headwind from the soon-to-expire overhead calls develops. As time passes and standard expiration nears, calls at the 218.50 and 220 strikes begin to lose sensitivity to SPY movement. Therefore, long S&P futures positions that were purchased as a hedge begin to be liquidated as the probability decreases that the SPY finishes above those strikes. The liquidation of these futures positions becomes a slight headwind. Finally, given that the largest put strikes immediately below the market reside at 213-215, we would expect support in the days ahead to be in the area of last week's lows.

"'The artist Christopher Wool has a word painting, 'Sell the house, sell the car, sell the kids.' That’s exactly how I feel -- sell everything. Nothing here looks good,' Gundlach said in a telephone interview. 'The stock markets should be down massively but investors seem to have been hypnotized that nothing can go wrong.' …Gundlach, who oversees more than $100 billion at Los Angeles-based DoubleLine."

-- Reuters, July 30, 2016

"Speaking with Fox Business network's Stuart Varney, Republican presidential candidate Donald Trump said that he had been invested in stocks but 'got out' with 'very good timing.' ...Strategists at investment bank Goldman Sachs are similarly downbeat in the short run. They downgraded their view on equities and expect the main U.S. and European indices to fall by about 10% in the next three months."

-- The Wall Street Journal, August 2, 2016

Potential negatives for the short term are the historically bearish August-September seasonality, the COMP bumping up against its all-time high, and the SPY facing possible options-related resistance overhead in the days ahead. Plus, the S&P MidCap 400 Index (MID - 1,562.55) is trading in the vicinity of last year's high, which may limit aggressive buying.

Additionally, like the situation before the June Fed meeting and the "Brexit" referendum, large speculators in the CBOE Volatility Index (VIX - 11.69) futures market have a record short position. These speculators have been wrong at extremes, so we are at increased risk of a volatility pop, just as we were in early June. If you are a trader, you should approach the market with these risks in mind. You may look to VIX futures options or VIX futures as a potential long portfolio hedge. If you want to see evidence of things getting a little shaky, you could wait for a break of the support levels we discussed above on various stock indexes, or wait for a VIX close back above 14.07, which is half 2016's closing high.

But, as we discussed last week, our intermediate- to longer-term outlook remains bullish. As you can see from the excerpts above, the SPY's breakout to new all-time highs and the Dow and COMP rallies from former resistance levels did not have the support of a current presidential candidate, a major investment bank, and a highly followed fund manager -- all who expressed negativity and considerable caution toward equities in the past week. The caution expressed by these influential voices should be music to the ears of contrarian investors. To the extent that such caution exists among other investors, there is ample fuel to support the market in the intermediate to longer term.   

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