If VIX Closes Above This Level, It's Time to Buy Put Options

With Fed uncertainty gripping the market, hedging against a volatility pop remains wise

Senior Vice President of Research
Sep 6, 2016 at 10:02 AM
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"Intraday volatility picked up relative to past days, as investors bid stocks higher on Yellen's comments. For those who pay attention to options open interest, notice the intraday highs and lows for SPY on Friday were around strikes with decent-sized open interest in the vicinity of Thursday's close. For example, the put-heavy 216 and 217 strikes were the area of Friday's lows, whereas the call-heavy 219 strike marked Friday morning's high. The lows on Friday were especially interesting at the area of July 27 close, option-related support, and the SPY's 40-day moving average, which has occasionally had importance."

-- Monday Morning Outlook, August 29, 2016

After reviewing my description of the previous week's SPDR S&P 500 ETF Trust (SPY - 218.37) price action -- which encompassed comments from central bankers late in the week in Jackson Hole, Wyoming -- I couldn't help but note the striking similarities with respect to last week's action. In fact, substitute "August employment report" for "Yellen's comments" in the excerpt above, and you pretty much have a description of last week's action in terms of the pivot points during the week.

Per the second graph below, note how the same strikes favoring either heavy call or put open interest for soon-to-be expiring SPY options came into play late in the week: heavy 216 and 217 strike put open interest was supportive, and the call-heavy 219 strike acted as resistance. Moreover, the July 27 close of $216.52, the date of the last Federal Open Market Committee (FOMC) meeting, was violated again intraday, but never closed below this level. Finally, the 40-day moving average, in the $217 area, was again supportive.

30 Minute SPY Chart September 6

SPY Open interest September 6



Like the stock market, which has shown intraday bursts in both directions resulting in no net movement, the same is true for rate hike expectations. The evening before the Jackson Hole, Wyoming, central banker meeting began, the probability of a rate hike in September (according to 30-day Fed funds futures prices) was 21%. After Janet Yellen's speech on Friday morning, the implied odds immediately fell to 18%, but this was reversed after hawkish comments later in the morning by Vice Chair Stanley Fischer. Equities sold off as Fed funds futures indicated a 35-40% chance of a tightening in September.

Last week, however, the implied odds of a September rate hike dropped again, after disappointing manufacturing data from the Institute for Supply Management (ISM) on Thursday and the employment report on Friday. On Friday morning, the implied odds of a rate hike were 18%, and then late Friday, they were back to 21% -- the exact rate hike expectations Fed funds futures players were anticipating just ahead of Jackson Hole.

The bottom line is Fed uncertainty appears to be gripping the market, even though Jackson Hole and a busy week of economic data last week had the potential to move equities out of a narrow trading range. Will any tidbits of news from this past weekend's G-20 summit, hosted in China, serve as a potential catalyst? Perhaps, especially if intentions for what might occur in Algeria later this month are revealed, when the Organization of the Petroleum Exporting Countries (OPEC) talks "production freeze" -- after failing to implement such a freeze when last discussed in April, with oil trading in the $40-per-barrel zone as it is now.

"…per a study our Senior Quantitative Analyst Rocky White did last week, when the SPX hits single-digit historical volatility readings 15 days in a row, the signal produces lower standard deviations of returns in the next month and two months, relative to the at-anytime readings. In other words, history suggests a low-volatility environment may be here to stay for a couple more months."

-- Monday Morning Outlook, August 22, 2016

Our trading floor discussion last Friday was highlighted by this question: How long will this low volatility in the market persist? After talking about the many events that had the opportunity to act as a catalyst for a breakout (or breakdown), upcoming events through the elections and the negative seasonality in September, we kept coming back to the study that our Senior Quantitative Analyst Rocky White did a few weeks ago, after the SPY/S&P 500 Index (SPX - 2,179.98) hit single-digit historical volatility readings for 15 consecutive days on Aug. 16.

The historical implications he found were as follows*:

  1. He took the total number of streaks that lasted 15 trading days (107 times before the recent one) and found the probability of the streak lasting another 21 trading days, 42 days, or 63 days (one, two, and three months). The chances of it lasting for another month was 44.9%. The chance of it lasting another two months was 28%, and the chance of it lasting another three months was 18.7%.

  2. Per the tables below, there's a slightly higher-than-normal probability of the market moving higher, which supports the popular saying, "Never short a dull market." That said, both advances and declines over one to three months were lower than normal, suggesting low volatility tends to persist.

SPX Tables September 6

*Keep in mind that these studies were done ahead of Jackson Hole and ahead of this past week's busy economic calendar, including reports on productivity, manufacturing and employment.


As it stands now, the CBOE Volatility Index (VIX - 11.98) -- with its inability to close above the key level of 14.07, which is half its 2016 calendar-year high close -- continues to indicate lower volatility, or a lack of sharp moves, in the immediate future. Perhaps a hint that volatility is on the horizon would be a daily close, or preferably a weekly close, above 14.07. Last week, the VIX popped over 14.07 intraday, but a close above this level was not to be. Keep in mind that volatility is not a measure of direction, so it is entirely possible for a breakout to occur within the context of low volatility. For equities, low volatility usually coincides with upside breakouts.

At this point, if you are looking to hedge your long portfolio against a sharp move lower in equities via SPY puts or VIX calls, it is perhaps best to await a close north of 14.07 on the VIX. It is the activity in VIX futures among large speculators and, more recently, the activity on VIX futures options among option traders that puts us on guard for a volatility pop in in the near future. Consider the following two points:

  1. Large speculator VIX futures players have the largest short position ever on VIX futures, per Commitment of Traders (COT) data. This group has historically been on the wrong side of major VIX movements when in an extreme position.

  2. Buy-to-open VIX futures put volume over 20 days fell below 400,000 contracts on Aug. 29. According to our Quantitative Analyst Chris Prybal, since 2013 there have been nine occasions that this occurred. In three of those instances, the VIX was higher by more than 30% 21 days later. On the contrary, there was not a single instance that the VIX was higher by 30% or more when VIX buy-to-open put volume totaled more than 400,000 contracts over 20 days. The bottom line is that from an absolute perspective, the probability of a major VIX spike is low -- but from a relative perspective, it is higher than normal.

So again, because the risk of a volatility pop is low absolutely in the near term, but also higher than normal when looking at the positioning of futures and options players, we are still advising the purchase of SPY puts or VIX calls only in the context of a hedge to your long portfolio. Moreover, given that VIX 14.07 has proven to be resistance, one might consider utilizing a hedge only if the VIX closes above 14.07.

Daily VIX Chart September 6

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