All Bets Are Off If SPY Breaks This Key Put Strike

As October options expiration approaches, the SPY 212 strike could play a crucial role in the stock market action

Senior Vice President of Research
Oct 10, 2016 at 8:34 AM
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Last week, investors navigated through all-too familiar headlines -- unemployment data, elections, Brexit, Fed speak. But a rare headline burst onto the scene and gained wide attention, too -- Hurricane Matthew.  

As the Category 3-4 storm bore down on Florida late last week, I couldn't help but think back to Hurricane Andrew -- a Category 5 storm that hit Florida in August 1992 (which was also a presidential election year) and caused about $25 billion in damage, or $43 billion in today's dollars. For those of you who remember this storm, you might also remember the term "tent city," which served as temporary housing for those who were displaced from their homes.

While not a Category 5 hurricane, the size of Matthew and its slow path along the Eastern seaboard is expected to cause major damage. I was curious as to how the stock market reacted in the days preceding Andrew in 1992 and the immediate aftermath. As I mentioned in a tweet late last week, the S&P 500 Index (SPX - 2,153.74) declined 2% in the week Andrew developed into a tropical storm and finally made landfall in Florida as a Category 5 storm on Aug. 24, 1992. Three weeks after its landfall, the SPX was up 3.4% from its Aug. 24 close.

"This week brings a new quarter, and with a new quarter, bulls hope for a breakout from the third-quarter consolidation."

-- Monday Morning Outlook, October 3, 2016

While the SPX has declined since Hurricane Matthew became a tropical storm on Sept. 28, the downturn is barely noticeable on a chart, and pales in comparison to the decline that the SPX experienced ahead of Andrew making landfall in 1992. In fact, the SPX's half-century mark of 2,150 worked in tandem with its 80-day moving average to contain multiple intraday sell-offs last week. So, unlike 1992, it does not appear the hurricane "rumor" was sold. At the same time, there is clear resistance around 2,168 -- a level we have discussed in the past. This is the site of the close on the day of the late-July Federal Open Market Committee (FOMC) meeting, which acted as support for weeks after that meeting, before finally being breached early last month.

In fact, by Friday's close, the SPDR S&P 500 ETF Trust (SPY - 215.04) experienced its 11th consecutive day in which a $215 handle was quoted, indicating a narrow range.  Moreover, the SPY finds itself at the mid-point of its highs and lows since the July breakout above the $212 area, which had marked highs on numerous occasions since February 2015. The midpoint between $212.00 and $219.50, which is a round 20% above this year's closing low in February, is at $215.75.

SPY daily chart 2016 1007

"…the SPX tends to decline in October of an election year, consistent with the theory that short-term uncertainty may weigh on investors in the weeks ahead of the election."

-- Monday Morning Outlook, October 3, 2016

In recalling that when Hurricane Andrew rolled through Florida that it was also a presidential election year, we were curious as to how stocks behaved preceding that election. For what it's worth, the SPX defied historical election-year October probabilities, as it bottomed on Oct. 9, ending a 6% decline that began in mid-September. The Oct. 9 bottom marked the beginning of a 5% rally into the November election. These events of 1992 simply reinforce the idea that while seasonality in October works against bulls, there are exceptions to the rule.

Finally, we are moving into that two-week window in which standard options expiration on Friday, Oct. 21 is in sight, which means options open interest on equity index and exchange-traded funds could influence the behavior of the stock market. Per the chart below, the SPY is currently trading above strikes with the heaviest put open interest. The implications are that if the SPY remains above these strikes in the days ahead, and as standard expiration gets even closer, short covering related to the expiration of these put options would be supportive -- potentially driving the SPY to the top of the range and toward the call-heavy 220 strike.  

The risk to bulls is a move below peak put open interest at the 212 strike. Given the huge put open interest at this strike, delta-hedge selling could generate sharp selling as those who sold the puts are forced to sell more and more S&P futures to be appropriately hedged against a spiral lower. Plus, other big put open interest strikes could act as magnets, such as the 210 or even 205 strike.  

Additionally, and as discussed above, SPY $212 is a breakeven level among some traders, particularly those who bought on the move through this level.  Those same buyers could be sellers on a move below $212.   

Therefore, as it stands now, the open interest configuration is a tailwind for the bulls in the weeks ahead. But if the 212 strike is breached, all short-term bets are off for bulls. And if the SPY trades below $214, it is likely that the $212 level will be tested once again. In this case, bulls will have to put up another fight, as they successfully did in mid-September.

SPY open interest October 1007

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