Watch Out for SPY 225 as Quadruple Witching Approaches

Traders could take profits on high-flying stocks as SPY hovers near a key year-to-date return this options expiration week

Todd Salamone
Dec 12, 2016 at 8:38 AM
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"... there is the possibility that +10% YTD on the Dow becomes significant in the days ahead as resistance, especially with the SPX trading back below the round 2,200 level… A short-term consolidation to work off overbought levels would not be a surprise, while a Dow move through its +10% YTD level while in an overbought condition would be impressive."
    -- Monday Morning Outlook, December 5, 2016

Last week's rally was truly impressive, especially in the context of an upcoming Federal Open Market Committee (FOMC) meeting on Dec. 14 -- where the odds of a rate hike are currently 97%, per data from the CME Group, which uses 30-day fed funds futures prices to calculate the probability of an interest rate hike. Investors will focus not only on whether the Fed raises rates, but will also pay attention to the FOMC's projections for the future to get a better read on how the rate-hike cycle could play out during the next several months.


From a technical perspective, during the past couple of weeks, I spelled out potential areas where buyers may take pause, including the Dow Jones Industrial Average (DJIA - 19,756.85) 19,000 millennium level, the 10% year-to-date (YTD) gain on the Dow, or -- as I observed in a tweet last week -- the 20% YTD gain on the iShares Russell 2000 ETF (IWM - 138.31), a popular exchange-traded fund (ETF) with an emphasis on small-capitalization stocks. On the contrary, buyers have not paused at these round-number levels and round-number YTD gain areas, despite the respective overbought conditions.

"... we are in that two-week window in which the market could be influenced by the positioning of option players on exchange-traded fund (ETF) and index options. As usual, our focus is on SPDR S&P 500 ETF (SPY - 219.68) options to identify key levels... The risk, however, is the unwinding of long positions related to overhead calls, particularly at the 220 through 222 strikes... The upside to these calls is that if SPY moves through the call-heavy 220 strike again, strikes up to 225 are stacked with fairly heavy call open interest and could act as small magnets. The SPY 225 level coincides with SPX 2,250, and half-century marks have proven pivotal in recent years. If you are a bull, the 225 level is a potential target if we continue the post-election rally into Christmas... "
    -- Monday Morning Outlook, December 5, 2016

We move into this week's standard December options expiration week with the SPDR S&P 500 ETF Trust (SPY - 226.51) trading slightly above the $225 area, which we discussed as a potential target area if the call-heavy 220 strike was taken out. The $225 level coincides with S&P 500 Index (SPX - 2,259.53) 2,250, a half-century mark -- and such half-century marks have historically acted as magnets during trading range behavior and/or key pivot areas after a big advance or pullback (see chart below). The importance of these half-century levels could be due to the heavy open interest that tends to build up on SPX and SPY options at these strike prices that represent half-century levels on the SPX.

Coincidentally, the $225 level on the SPY is also around its 2016 10% YTD return level, displayed in the first pane of the chart below. I point this out as the -10% YTD area marked an important SPY bottom in February. That said, if momentum buyers predominate as we get ready to close 2016, the SPY $225 area may mean very little. Nonetheless, it is worth pointing out why it could be a hesitation area in the immediate term.

spy daily ytd returns 1209

There are a few macro events that could impact the equity market this week, including the outcome from Saturday's non-OPEC member meeting in Vienna, the Fed interest rate decision, and a plethora of economic data due out on Wednesday and Thursday.

The risks to bulls remain the same as last week, from an options perspective, as long positions associated with call open interest could be unwound if the SPY breaks back below significant call open interest strikes. An additional short-term 5-point SPY rally is not as likely after the move through the 225 strike last week, as call open interest is not stacked like it was from 220 to 225. These "stacked" calls may have contributed to a little bit of extra firepower via delta-hedge buying last week. The next big call magnet is at 230, and it would likely take a significant gap higher for this strike to come into play, as there is very little in terms of magnets at the 227, 228, and 229 strikes (unless a notable build occurs this week). That said, these "tall" open interest call strikes have tended to expire out of the money throughout 2016.

If a pullback occurs, we see potential support at the SPY 222 strike, where call and put open interest are about equal after major put adds at this strike in last Thursday's trading. A break of this strike should not shake bulls from a technical perspective, as the next potential support area is around the 220 strike -- a round number equivalent to SPX 2,200, and the current site of the ETF's 20-day moving average.

spy dec open interest by strike

Finally, I will leave you with some December options expiration week statistics put together by Schaeffer's Senior Quantitative Analyst Rocky White, as displayed in the table immediately below. From a win-rate perspective, the historical statistics favor the bulls. But, like other expirations, the average loss is bigger than the average win -- particularly during quadruple witching expiration weeks -- which makes the risk-reward less appealing.

spx expiration week returns 1209

Typically, the big losses during expiration week are caused by big put open interest strikes below the market that act as magnets during sell-offs. But if a big loss occurs this week, it could be attributable in part to: (1) the unwinding of long positions related to expiring call open interest, with the SPY directly above multiple call-heavy strikes; and (2) profit-taking as investors look to sell a 10% YTD profit, just as they bought on a 10% YTD decline.


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