SPY 'Call Wall' Falls, But What Will VIX Options Expiration Bring?

Following last week's Fed rate hike decision, traders should consider playing bonds via TLT in the short term

Senior Vice President of Research
Mar 20, 2017 at 8:34 AM
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"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."
    -- Monday Morning Outlook, March 13, 2017

Judging by the stock market's reaction to the outcome of the Federal Open Market Committee (FOMC) decision last Wednesday, market participants were satisfied. The Fed raised the federal funds rate by 25 basis points for the second time in three months, signaling their perception of continued improvements in labor and inflation data. Following strong employment data earlier in the month, there were whispers that the Fed might increase its projected number of rate hikes in 2017 to four -- but the committee reiterated its forecast for three hikes this calendar year, suggesting future tightening will continue to be gradual. Therefore, one might characterize Wednesday's action as a "relief rally" after the Fed maintained its interest rate projections for 2017.

The S&P 500 Index (SPX - 2,378.25) continued its winning ways -- although, prior to the FOMC meeting and for the first time in 36 trading days, it closed slightly below its 20-day moving average. Last week, we presented data on the historical implications of the SPX closing 33 consecutive days above its 20-day moving average. As you can see on the table immediately below, and as noted in this space last week, lengthy streaks in which the SPX closes above its 20-day moving average typically begets more of the same bullish momentum in the two weeks to three months after the signal.

Prior to the most recent signal on March 8, the last time the SPX closed 33 consecutive days above its 20-day moving average was Dec. 22. There was a little drawdown after the Dec. 22 signal -- as expected, based on the history of this signal. But two months later, the SPX was trading higher by 4.5%, above its expected and average positive returns, historically.

spx returns after 20 day streak 0317

"As the FOMC meeting comes into focus, keep in mind that it is standard options expiration week... 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."
    -- Monday Morning Outlook, March 13, 2017

The excerpt above refers to the SPDR S&P 500 ETF (SPY - 237.03), of course, as I observed that standard March options expiration on March 17 could see the SPY 240 strike potentially act as a "capper" to a rally attempt. Not only did this area mark the high in the first trading day of March, but significant call open interest had built up at this strike, primarily driven by sell-to-open volume. As such, hedged players who bought the calls were likely to short more S&P futures as the SPY approached this strike, since the call option becomes more sensitive to changes in the SPY.

I find it interesting that in the immediate aftermath of the Fed decision, the SPY shot higher -- but its high point was $239.44, about half a point below the key 240 strike. On Thursday, the SPY declined from the start of the trading day, pushing further below the 240 strike. The exchange-traded fund (ETF) then went ex-dividend on Friday, which explains the gap lower seen on the chart below.

The good news for bulls is that the 240-strike "call wall" disappeared with standard March options expiration last Friday, when more than 160,000 calls at this strike expired worthless. As we move into the last two weeks of trading in the first quarter, there is a SPY weekly options expiration on March 24, followed by quarterly options expiration on March 31. Now, the combined call open interest at the 240 strike is more than 60% below the levels SPY was facing during March expiration week. In layman's terms, the "call wall" is much smaller for expirations on the immediate horizon.

spy hourly chart 0317

Turning to the sentiment backdrop, we are seeing caution creep into the market, although the current level of caution is not anywhere near the fear that prevailed pre-election. Short interest on SPX component stocks edged higher again in the last reporting period, even as the SPX carved out another new high. This is a welcome sign for bulls, as short interest is higher relative to a month ago, and so too is the market -- but it is a welcome sign to the extent that the SPX does not break down below support levels. With short interest rising off its recent multi-month low, the shorts might sense opportunity on an index breakdown and become emboldened, and a sharp build in shorting activity would likely pressure stocks.

Additionally, we are seeing bullishness recede in the weekly National Association of Active Investment Managers (NAAIM) survey. In fact, the 10-week moving average of the average long position among these active managers is rolling over from an extreme high. Per the chart below, previous rollovers from extreme highs have preceded corrective periods for stocks. However, there have been instances in which the market's momentum continued, despite extreme optimism receding among the active manager group.

naaim sentiment 0317

Finally, the standard expiration of CBOE Volatility Index (VIX - 11.28) futures options occurs this week. Call open interest on VIX options is at a record level, with more than 8.3 million call contracts outstanding, of which 3.8 million expire this Wednesday morning. The implication is that -- to the extent that the expiring VIX calls are hedges to the enormous short position among large speculators on VIX futures (per recent Commitments of Traders data), or are hedges to long portfolios -- the days immediately after VIX options expiration are when we are most vulnerable to a volatility pop, as unhedged investors are more likely to panic on negative headlines.  

All of this would suggest you continue the course of acknowledging the risk but also playing the momentum via call options as a speculative or stock-replacement play, as options remain cheap with earnings still a few weeks away. I remain bullish on gold, and I also think bonds, via the iShares 20+ Year Treasury Bond ETF (TLT), offer decent reward vs. risk over the next month. TLT rallied in the month after the Fed last raised rates in December, and with CoT large speculators showing signs of unwinding a multi-year record short position on the 10-year Treasury note, this could be an attractive asset in the weeks ahead. But if TLT breaks $116, all bets are off.

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