The Maximum Pain Point for SPY March Options Traders

SPY could be stifled this March options expiration week as traders eye the Fed rate hike forecast

Senior Vice President of Research
Mar 13, 2017 at 8:40 AM
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"The explosive advance last week occurred after a warm reception to President Donald Trump's congressional address... The last time multiple benchmarks flirted with round numbers simultaneously was late January, just days after the inauguration and ahead of the Feb. 1 Fed meeting, when Dow 20,000, SPX 2,300, and S&P MidCap 400 Index (MID - 1,739.50) 1,700 were in play. Equities flat-lined for just over two weeks, as their 20-day and 40-day moving averages played catch-up before the mid-February 'lift-off'... one potential scenario ahead of the March 15 Federal Open Market Committee (FOMC) decision on interest rates is a short-term consolidation, much like the late-January/early February action when the February FOMC meeting was in focus."
    -- Monday Morning Outlook, March 6, 2017

The S&P 500 Index (SPX - 2,372.60) broke a six-week win streak by ending lower last week, pulling away from the round 2,400 level I recently highlighted on Twitter as a potential speed bump, while other popular benchmarks stared at potential round-number resistance at the same time.

The SPX pullback was minimal, with last week's low just above the half-century 2,350 mark -- which I envisioned in a commentary could act as a short-term magnet, like 2,250 did this past December (circled in the graph immediately below).  

spx 20-day half century levels 0310

Moreover, the SPX's rising 20-day moving average played "catch up" last week, as this trendline marked last week's Thursday low. The SPX has not closed below its 20-day moving average since January. Historically, such SPX win streaks favor the bulls, per the tweet and quantified research that follow.

spx 20-day streak data 0310

The new presidential administration remains in focus, particularly with respect to healthcare reform and -- as announced on Friday -- trade reform, with revisions to the North American Free Trade Agreement (NAFTA) on the horizon. Moreover, currencies and the dollar are likely to carry some weight with investors, as Treasury Secretary Steven Mnuchin meets with G-20 finance ministers and central bankers in Germany at the end of this week.  

Additionally, all eyes will be on the Federal Open Market Committee (FOMC), which on Wednesday is expected to boost the federal funds rate by 25 basis points and update its rate hike forecast for the remainder of this year. The probability of an increase in the fed funds rate (using fed funds futures prices) was 93% as of Friday afternoon, following two impressive payrolls reports last week. The probability of a rate hike can be found daily at CME Group's web site.

Assuming the Fed raises its benchmark rate by 25 basis points, the bigger focus will be its projections for the remainder of the year. There has been emerging talk, following the strong jobs data, that Wall Street is beginning to brace for three to four interest rate hikes in 2017. In mid-December, the Fed raised its projected number of rate hikes this year from two to three, and the market subsequently stalled through the end of the year. With a rate hike of 25 basis points baked into the market, the projections for the remainder of 2017 will likely be the focus of market participants; that is, unless the Fed does not raise the fed funds rate, or hikes it by more than expected.

As the FOMC meeting comes into focus, keep in mind that it is standard options expiration week. Given the open interest that tends to build up over time on standard options, big open interest strikes can exert their influence on the market's behavior in the immediate term.  

Below is the March put and call open interest configuration for the SPDR S&P 500 ETF Trust (SPY - 237.69). The huge 240-strike call open interest is noticeable, and acted as resistance earlier this month. Upon digging into this further, the call open interest at the SPY March 240 strike was primarily accumulated via sell-to-open activity -- so capping action, much like that which occurred two weeks ago, is to be expected. Unlike instances where the open interest is bought to open, the strike does not act as a "magnet," but more like a "call wall," as those who bought the calls from sellers short an increasing number of S&P futures as the call becomes increasingly sensitive to SPY movement. From an options-related perspective, it would not be surprising to see the SPY 240 strike -- which coincides with its all-time high -- act as resistance, at least through this week.

If the support zone around SPY $235-$236 is broken, the $230 level is where the maximum pain is -- or the level at which the greatest number of put and call open interest contracts expire worthless at March expiration. This level, for what it is worth, is around the SPY's 50-day moving average.

SPY would be vulnerable to exaggerated selling on a break of that put-heavy 230 strike, where open interest is dominated by put buyers. Breaks of big open interest strikes that were driven by put buyers set into motion a process called delta-hedge selling, particularly around expiration. Currently, the risk of this is low, but a Fed meeting looms.

spy march open interest strikes 0310

As a side note, standard CBOE Volatility Index (VIX - 11.66) options do not expire until Wednesday, March 22. For what it's worth, the current 7.7 million contracts in VIX call open interest is closing in on last month's VIX call open interest record of 8.4 million contracts.

To the extent that some of this call open interest represents hedges to the enormous VIX futures net short position among large speculators (as noted in the weekly Commitments of Traders report), the risk of a volatility pop is dampened a bit, as this is a group that will not panic if appropriately hedged. That said: if March VIX futures (VXc1 - 12.52) are to move through the call-heavy 16 and 17 strikes -- which is a remote possibility as of this writing -- VIX futures buying may ramp up among those who sold VIX calls, as this open interest is made up of mostly opening buyers. In other words, a move through 16 and 17 could be enough to spark a quick move to the last call-heavy strikes in the 23-24 zone.

vix futures open interest by strike 0310

"If you are in commodities, the energy and copper sectors are among those with the greatest risk, as CoT large speculators are extremely long copper and oil futures contracts amid so-so price action... However, gold continues to be a sector within the commodities market that I like, given its strong price action this year. This occurs after this once-crowded trade has become much less crowded."
    -- Monday Morning Outlook, February 27, 2017

My message from the last few weeks remains the same. Do not fight the tape -- so with the trend higher, do not disturb your bullish positions. Given the risks associated with growing optimism from the pre-election environment of outright fear, use call options to play the trend higher, or as a stock-replacement strategy. If you are in commodities, consider gold as your long play -- but avoid energy, or use put options to play the downside risk. The energy complex got more intriguing for bears last week after crude oil broke below the $50 level. There is a huge long position in crude oil futures and, if unwound, this could prove very painful for energy bulls.

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