Why We're Following the SPY 125-Day This Week

Traders should watch the SPY 125-day moving average as the stock market looks to break out of a trading range

Senior Vice President of Research
Oct 24, 2016 at 8:56 AM
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"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... 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... 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."  
-- Monday Morning Outlook, October 10, 2016

In revisiting my market outlook from two weeks ago, I discussed key levels and significant strikes on the SPDR S&P 500 ETF Trust (SPY - 213.98) as October options expiration was nearing. As you can see on the intraday SPY chart below, when the put-heavy 214 strike was broken, there were a couple of failed retests prior to a quick revisit of the significant $212 level -- significant from both a chart- and options-related perspective.  

Fortunately for bulls, this level/strike was successfully defended, just as it was in the month of September, as the risk was a break of the 212 strike leading to a short-term market meltdown. Unfortunately for bulls, however, short covering related to the expiration of big put open interest strikes immediately below the market did not generate a strong enough tailwind to push the SPY significantly higher. 

SPY 30 minute 1022

As the result of a tame October expiration week, SPY remains locked in a trading range that began with a weekly expiration Friday sell-off on Sept. 9. Since that date -- a period that has encompassed 31 trading days -- SPY has closed between $212 and $217 on 30 of those days. Note on the chart immediately below that the recent highs in the $217 area are a replay of the action in late July, when this level acted as a lid. Additional resistance is in the $219.50 area, the August-September peak, which is: 1) 20% above the February 2016 low; 2) 10% above the late-June “Brexit” trough; and 3) just below the round number $220 level that equates to the 2,200 century mark on the S&P 500 Index (SPX - 2,141.16).

SPY daily trading range 1022

Although formidable resistance is just overhead, it appears there is strong support below. In addition to the importance of $212 discussed above, note how the 125-day moving average -- a generally under-the-radar indicator -- is situated just above $212. This moving average equates to about six months of trading. It's not a widely followed trendline, but it's one that played an important role on a multitude of pullbacks from 2013 through the third quarter of 2015 (see chart below). A strong rally from this moving average, followed by a breakout above the August and September highs, would potentially indicate the market is about to embark upon a trending phase higher. But, buyer beware; breaks of this trendline have sometimes led to sharp, short-term selloffs of 5-10%.

SPY 125 day moving average 1022

Above said, a break of the SPY $212 level remains a risk to bulls. In the event this significant area is broken, a glimmer of hope would be the $210 area holding as support. This round-number options strike is the only one with in excess of 50,000 puts in open interest in the weekly option series that runs through Nov. 11, which is just a few days after the Nov. 8 elections.



“Fears of a bond-market crash, a breakdown in globalization, a new crisis in the euro area? There were a bevy of reasons for fund managers to push their cash balances to 5.8 percent of their portfolios in October, up from 5.5 percent last month, matching levels not seen since the aftermath of the Brexit vote. The share of cash hasn't been higher than that since November 2001, shortly after the terrorist attacks in the U.S. The amount of dry powder in portfolios is above that seen during both Europe's sovereign-debt crisis and the U.S. debt-ceiling debacle, according to Bank of America Merrill Lynch's monthly survey of money managers.”
-- Bloomberg, October 18, 2016

“CNBC interviews with well-known, and influential, money managers David Tepper, Carl Icahn, and Jeffrey Gundlach, all of whom expressed a cautious view of current market conditions”
-Briefing.com, October 20, 2016

Over the course of the current trading range, caution has grown. Fund managers have increased cash positions, short interest has grown on SPX component stocks, and the SPY has experienced the greatest amount of redemptions among all exchange-traded funds (ETFs), per data from ETF.com.  

A continued build in this caution will likely cap rallies in the immediate term, as we move into the heart of earnings season this week and next, and in advance of the elections on Nov. 8. In fact, after nearly 5 million SPY, iShares Russell 2000 ETF (IWM), and PowerShares QQQ Trust (QQQ) put options expired on Friday -- representing about 20-25% of all outstanding puts on these ETFs -- we wouldn’t be surprised to see an influx of put purchases in the days ahead as traders replace the portfolio insurance that expired last week.  

For now, the build in caution should be embraced by bulls, especially if equity benchmarks remain above support levels in the weeks ahead, and as some uncertainty begins to dissipate. To the extent that SPY, for example, holds above support levels discussed above, it remains only a chip-shot away from its August-September all-time highs. As such, the rising caution represents future buying power that could easily push SPY through the resistance levels we discussed.   

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