Did SPY Options Help Trigger Friday's Sell-Off?

The SPDR S&P 500 ETF Trust (SPY) is currently trading north of heavy put open interest at the September 210 strike

Senior Vice President of Research
Sep 12, 2016 at 9:44 AM
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"In light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months."

-- Federal Reserve Chair Janet Yellen, Jackson Hole, Wyoming, August 26, 2016

Standard September options expiration week is upon us. This year's expiration is setting up similarly to last year, with the Federal Open Market Committee (FOMC) scheduled to meet soon and the SPDR S&P 500 ETF Trust (SPY - 213.28) sitting just above a major put strike -- with more than 190,000 contracts in open interest at the September 210 put -- just as it was last year. The meeting has been eagerly awaited, after comments from Fed Chair Janet Yellen late last month indicated the case for a rate hike had strengthened in recent months, and Vice Chair Stanley Fischer immediately following with hawkish comments.  

Not grabbing headlines was that the Fed would remain data dependent. This might prove relevant, however, as economic data released since Yellen's late-August speech has been far from impressive, driving expectations for a rate hike back to where they were ahead of the central banker meeting in Jackson Hole. But things changed again last Friday, as both equities and bonds declined sharply after voting FOMC member Eric Rosengren indicated the U.S. has remained immune to a slowdown overseas, and therefore, the economy could overheat if interest rates remain unchanged for too much longer.

Rate-hike expectations moved higher, albeit only modestly, as investors drove both stocks and bonds lower. We find it extremely interesting that last year at this time, Fed funds futures were indicating a 23% probability of a rate hike -- about the same as now. That said, expectations among economists for a rate hike in September 2016 are much lower than last year. Currently, only 13% of economists expect a rate hike this week, according to a poll by The Wall Street Journal, compared to about 45% of economists expecting a September 2015 rate hike -- which didn't come.

"… 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."

-- Monday Morning Outlook, September 2, 2016

Friday’s equity dump resulted in a volatility pump, as the CBOE Volatility Index (VIX - 17.50) finally closed above the 14.07 level, after failing to do so -- despite valiant attempts -- during the entire month of August. We keyed on 14.07 after noticing this was half its 2016 closing high. Based on the strategy we discussed last week, this would suggest a SPY put or VIX call hedge is prudent for your portfolio, especially during this time of Fed uncertainty, plus other macro events on the horizon -- including a European Union (EU) summit at the end of the week and an Organization of the Petroleum Exporting Countries (OPEC) meeting in Algeria late in the month.  

On one hand, multiple Fed governors have hinted at a rate hike. But the market is assigning a low probability of a rate hike occurring. This is evident in the behavior of fed funds futures speculators, who are assigning about a 1-in-4 chance of a rate hike less than a week before the meeting -- and economists' low expectations, especially as compared to last year. Therefore, a rate hike this month would be a bigger surprise to the market than it would have been at this time last year, which is a risk worth hedging.

As I've been saying for weeks, large speculators in VIX futures have their biggest net short position ever, and have historically been dead wrong at key turning points in volatility. While they may one day be right, this is something to take notice of in terms of the risk of a volatility pop that drives the VIX into the 20-21 area, or the June highs in the 26-27 region.

VIX popped above 14.07 (horizontal line) on Friday -- 14.07 is  half its 2016  closing high, and had been acting as resistance on a closing basis

Daily VIX since July 2016

"Rate Hike Fears Slam Stocks"

-- CNBC headline, September 9, 2016

Continued volatility pop risk aside, is there a silver lining for bulls? From an options and chart perspective, there is.   

As you can see in the graph below, Friday's carnage likely means that for options expiring today, Wednesday, and Friday, selling related to the unwinding of long positions associated with overhead calls is over. Moreover, selling of S&P futures is near over related to the breach of the put-heavy 215 strike. In other words, those short the puts and betting on a close above 215 by expiration of those options were likely forced to sell S&P futures to hedge against a further decline in the SPY. The "call unwind, put delta hedge" scenario could explain why equities closed sharply lower, even though the odds of a rate hike increased only modestly, from 18% on Thursday evening to 24% on Friday. The SPY move seemed huge relative to a mild increase in Fed rate-hike expectations, even though headlines said rate-hike fears caused the selloff.

SPY open interest configuration

From a chart perspective, we move into expiration week trading just above a long-term resistance level -- specifically $212, which acted as resistance from December 2014 up until the breakout above it in July 2016. Traders who missed the breakout move could be lined up and ready to buy on a move down to this former resistance level. So, after Friday's heavy selling, a bull might take some comfort in the fact that there is little short-term risk in the market, from an options-related and chart perspective.   

SPY weekly chart since september 2014

The bottom line is, with plenty of potential market-moving events on the horizon, we remain at risk of a volatility pop -- so SPY puts and/or VIX calls are appropriate at this time. This is especially true with Fed governors talking about the potential for a rate hike, but economists, volatility futures speculators, and fed funds futures players far from buying into such talk -- indicating a September rate hike isn't factored into the market.

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