Why This Week Will Be Pivotal for VIX

The key strikes to watch as VIX futures and standard equity and index options approach expiration

Senior Vice President of Research
Apr 17, 2017 at 8:38 AM
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"... the standard expiration of CBOE Volatility Index (VIX - 11.28) futures options occurs this week... 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."
    -- Monday Morning Outlook, March 20, 2017

- Concerns about a government shutdown if Congress cannot agree on a budget by month end?
- Uncertainty with respect to the Fed rate increases and balance sheet reductions?
- Trepidation amid yield curve flattening and how this might impact economic growth?
- Worries that tax reform and massive infrastructure spending are dead on arrival?
- Anxiety about overseas developments (deteriorating U.S.-Russia relations over Syria, North Korean nuclear threat, European populism putting the future of the eurozone in question)?
- All of the above?

After a couple weeks in which the CBOE Volatility Index (VIX - 15.96) volatility futures crept higher, it finally arrived last week -- a VIX pop, coincident with headlines on the geopolitical front and perhaps other lingering uncertainties, as set forth immediately above.  

Even in the weeks before my March 20 comments excerpted above, I had been cautioning about the increased risk of a volatility pop that would arrive with weakness in equities, as the massive post-election short covering that had helped drive stocks higher had disappeared.

Moreover, without the support of short covering, multiple indexes were battling round-number resistance levels, and large speculators on VIX futures were in an extreme net short position -- the likes of which had not been seen since September 2016 -- weeks ahead of the election. I had warned that this group is usually wrong at key turning points in volatility, and it is apparent that this time is no different.  

Last week, in fact, the VIX advanced to its highest level since November, and April VIX futures (VIXAPR - 16.30) are now roughly 40% above their March 17 close, having experienced little to no downside movement since the short positions on VIX futures were established earlier this year.

cot large speculators vix futures net positions 0415

We move into the standard options expiration week with a key question moving forward: "Has volatility peaked?"  

Per an observation that I made on Twitter, the VIX's Thursday and Friday highs occurred in the 16.05 area, which is one-half of 2016's intraday high at 32.09. Additionally, the VIX 15.87 level is 50% above this year's closing low of 10.58. Therefore, from purely a technical perspective, and given how the VIX has a historic tendency to peak at half-highs and/or round percentage levels above key lows, bulls might take some comfort that volatility is at or near a short-term peak.

However, the risk in this assessment is that there is plenty of upside in volatility futures if large speculators, who were in a little bit of short-covering mode in the past couple of weeks, eventually move into a rare net long position amid the many lingering uncertainties on the domestic and international fronts.

With the standard expiration of options, this week could prove pivotal as to where volatility heads in the near term. Wednesday morning, for example, is the standard expiration of April VIX futures options. If you follow me on Twitter, you know that it is not unusual for more than 90% of VIX call options to expire worthless, mainly because many calls tend to be purchased far out of the money.

To the extent that some of the outstanding April VIX call open interest represents hedges to short VIX futures positions, we may not see a further advance in volatility until after these VIX calls expire and force the hands of those who are short volatility and are looking to cut losses or re-establish hedges via VIX calls. If they decide enough is enough and cover their short volatility positions, this could be supportive of a sharp move through the resistance areas discussed above. If they replace the expired protection via low-delta, out-of-the-money, short-term VIX calls, this action would be less supportive of a volatility surge relative to covering of existing short volatility positions.

The less likely scenario, but one that carries higher risk than usual in the first two trading days of this week, is a sharp move to the last call-heavy strike at 25. Through a process called delta hedging, sellers of VIX calls may be forced to buy April VIX futures to guard against additional upside moves in volatility. The high call open interest strikes are apt to act as magnets as call sellers hedge against a volatility spike that generates big losses on the calls they sold.

april vix futures open interest by strike 0415

vix daily chart 0415

"The RUT remains the most vulnerable of the benchmarks discussed, as it has been trading sideways since the mid-December rate hike and could be forming a bearish 'head and shoulders' pattern. ... small caps remain an area to avoid, given the shakier technical backdrop relative to larger-cap names, and specifically larger-cap technology stocks."
    -- Monday Morning Outlook, April 10, 2017

Despite April VIX futures advancing 40% since the March 17 close, the S&P 500 Index (SPX – 2,328.95), a large-cap benchmark, is down only 2% in this period.  But the SPX has not made a new all-time high since March 1, the day after President Trump's State of the Union address, and has shown visible weakness since the March 15 Fed rate hike.

With the index's break of the 50-day moving average last week -- a break that garnered a lot of attention -- it remains above its 80-day moving average, situated at 2,321, which provided short-term support in September. But a break of the 80-day moving average, followed by a failed retest, led to significant weakness in October and November. And, for what it's worth, the SPX 2,324 level represents a round $20 billion market capitalization for the index.

This Friday is the expiration of standard April options, so with that I will bring to your attention the open interest configuration of the SPDR S&P 500 ETF Trust (SPY - 232.51), which is one-tenth the SPX. Note the significant put open interest at the 232 strike, which is roughly equivalent to 2,320 on the SPX, and around the 2,321 and 2,324 levels discussed immediately above. A break below the SPY 232 strike would heighten the probability of a decline to the 230 strike, which is the last significant heavy put strike in the April series.

If such a move occurs early in the week, it is possible that the 228 and 229 strikes could see a continued build in put open interest, making them "magnets," too. The upside, for bulls, is that if the SPY can stabilize from the "get go" this coming week, short covering related to the expiring put open interest could be a tailwind in the days ahead.

spy april open interest by strike 0415

The small-capitalization Russell 2000 Index (RUT - 1,345.24) remains on shakier technical ground relative to the SPX, as it comes into the week below its 2016 close at 1,357 and a new 2017 closing low, albeit slightly. The RUT has previously troughed at 1,345 on a closing basis in January and March, but as I mentioned last week, a break below the 1,345-1,350 area triggers a bearish "head and shoulders" pattern that would target a decline to 1,275.

Therefore, I continue to advise avoiding the small-cap space if you are looking to reduce equity exposure amid the rising volatility and the many uncertainties lingering.

"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."
    -- Monday Morning Outlook, March 20, 2017

If you established long positions on the iShares 20+ Year Treasury Bond ETF (TLT - 123.47) last month, you are pleased with the TLT's move above the January highs this past week. There has been a lot of short covering among futures players, so from that perspective there is the risk that the bond market has lost some support from those betting against it last month. But the technical breakout is reason to continue holding long positions. If the TLT closes below $121.00, site of a trendline connecting lower highs in 2017, close your long position.

tlt daily chart 0415

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