Why a Break of SPY 210 Is The Biggest Risk Right Now

From a long-term technical perspective, the bull case remains intact as long as the SPDR S&P 500 ETF Trust (SPY) remains above its 40-month moving average

Senior Vice President of Research
Sep 19, 2016 at 8:22 AM
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"… 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 … [W]ith 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."
-- Monday Morning Outlook, September 12, 2016

Admittedly, by the time last week's commentary was posted to our website on Monday morning, the CBOE Volatility Index (VIX - 15.37) was trading in the 20 area, gapping higher following a sharp advance the previous Friday. This round level represented the lower target range that I had given you and marked a 75% advance from the VIX's Sept. 8 low. Therefore, there was little that was actionable as of Monday morning.

But the market reversed its Monday morning losses, and rallied sharply into the close. At the same time, the VIX pulled back to the 15 area by the afternoon, giving you a more reasonable entry point to add a SPDR S&P 500 ETF Trust (SPY - 213.37) put hedge, or call options on VIX futures.

As a reminder, we used a VIX close above 14.07 as the trigger for bulls to put on a portfolio hedge. The VIX 14.07 level -- which is half the 2016 closing high -- had served as resistance on a closing basis throughout the month of August, following a move below this level in early July after a June volatility spike.

There is plenty of room for the VIX to move higher if it eventually challenges the June highs, or even its highs from the beginning of the year. So, a continued upswing in volatility remains a looming threat to market bulls, especially with a plethora of "known unknowns" (known events with unknown outcomes) on the calendar that could influence the equity market in the days and weeks ahead -- such as the European Union (EU) summit that began this past Friday in Bratislava, Slovakia (with "Brexit" fallout likely to be discussed), central bank meetings in Japan and the U.S. in the middle of this week, followed by a special Organization of the Petroleum Exporting Countries (OPEC) meeting at the end of the month (and not to mention U.S. elections in early November).

Whether or not another volatility spike occurs in the near term, it is a fact that large speculators on VIX futures were once again positioned incorrectly for a major move in volatility. As I have been saying for weeks, this group has historically been dead wrong when moving into an extreme position of any kind. And so it was that they moved into their biggest net short position ever during the weeks in which volatility, as measured by the VIX, languished between 12-14. But this volatility measure suddenly popped 75% in only a few days.

Another volatility pop would likely push the VIX into the range between 26-30. If such a spike occurs, it would likely happen after the expiration of standard September options on VIX futures, which occurs Wednesday morning (the last day to trade standard September expiration VIX futures is tomorrow). Most of the time, a large majority of VIX call options expire worthless. And, as you can see on the VIX September open interest configuration below, sellers of VIX call options will be especially happy if the Wednesday morning settlement price is below 17.  

Note also that these options will expire before the Federal Open Market Committee (FOMC) releases it decision on monetary policy. As of Friday, one-half of the total outstanding call open interest in VIX futures was contained in options expiring on Wednesday, Sept. 21. To the extent that these calls are hedges to the huge short position on VIX futures, one would expect VIX futures players to cover short VIX futures positions and/or replace expired VIX calls with new hedges via rolling activity, putting a floor on volatility in the immediate days ahead.

VIX open interest configuration for 9/21 expiry series
mmo vix open interest september 16

This past Friday was the expiration of standard equity, index, and exchange-traded fund (ETF) options. Per the tweet above, the past two Fridays have been similar, in that sharp selling occurred following breaks below the put-heavy 215 strike. As we have said in the past, the bigger the open interest, the more likely it will act as a magnet during periods of weakness. Moreover, the bigger the open interest, the sharper the selling that is expected, as sellers of those puts are forced to short S&P 500 Index (SPX - 2,139.16) futures to hedge against further losses (delta-hedge selling).

Bulls can take some comfort in the fact that the heavy selling episodes these past two Fridays were short on duration, as the SPY quickly found support in the $212 area, which was the location of the last heavy put strike in the immediate vicinity of the SPY. Coincidentally, and as we discussed last week, the $212 area was long an area of resistance that is acting as support at the moment.


SPY open interest configuration for 9/21 expiry series
mmo spy open interest september 16

mmo spy weekly september 16

As discussed above, there are plenty of macro events taking us through the end of the month. With that said, we combined all options that expire on the SPY through the expiration of the weekly/quarterly options on Sept. 30. As it stands now, the biggest risk is a break of the 210 strike, where there are more than 220,000 put contracts outstanding. A break of this strike would likely ignite sharp selling that pushes the SPY down to the 207-208 area quickly.

A huge "call wall" is visible at the 220 strike, which is in the vicinity of the significant $219.43 price point. With the intraday high at $219.60, we see the $219.43 area as important because it is just below a key round level that tends to attract heavy call open interest, and is 20% above this year's February closing low, which likely inspires profit taking.

If there is good news in the SPY open interest configuration through the end of the month, it is that there is little in the way of long positions being unwound due to overhead calls in the immediate vicinity of the SPY, and there is the potential for a gradual unwinding of short positions related to expiring put open interest in the absence of a negative surprise. In other words, the put-heavy 210 and 212 strikes will either be a friend or a foe amid the macro events that I have discussed.

SPY open interest configuration for all expirations through 9/30
mmo spy open interest all september 16

The risk of a VIX pop remains, as a plethora of VIX calls are set to expire amid uncertainty related to multiple "known unknowns" in the coming weeks. Therefore, a portfolio hedge is prudent for bulls in a scenario in which a disappointing outcome pushes the SPY below potential support in the 212 area. 

From a longer-term technical perspective, the bull case remains intact as long as the SPY remains above its 40-month (roughly three-year) moving average, and therefore we still advise against disturbing longer-term positions. As you can see on the graph below, this trendine has had significance from a "support," "resistance," and "cross-over" perspective during the past 20 years. At the same time, with this trendline situated 10% below the recent highs, a pullback to this area might be too much to endure for some -- thus, a hedge may be prudent for those investors.

mmo spy monthly september 16

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