How the SPY 240 Call Wall Could Impact Stocks

Another post-Fed rally could be on tap for stocks after the central bank opted to leave interest rates untouched

Senior Vice President of Research
May 8, 2017 at 8:22 AM
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Last week, we presented you with multiple headlines that took place in the prior week, ranging from French elections to North Korea and multiple headlines out of Washington, D.C. This past week was no less newsworthy, with the House passing a healthcare reform bill and Congress agreeing on a spending bill. Syria was also back in the news, as Presidents Trump and Putin discussed the situation over the phone.

There was pre-election coverage out of France, as well, with observers noting that a victory by establishment candidate Emmanuel Macron over anti-European Union rival Marine Le Pen was likely factored in, as polls showed Macron leading by a large margin. The gap between German and French bond yields narrowed significantly, and the euro rallied against the safe-haven yen.

Perhaps most importantly, the Federal Open Market Committee (FOMC) was in focus mid-week, after releasing its latest decision on interest rates. Based on the behavior of the S&P 500 Index (SPX - 2,399.29) and SPDR S&P 500 ETF Trust (SPY - 239.70) after Fed meetings in recent months, the FOMC policy decision may be the most relevant headline impacting stocks, as Fed Chair Janet Yellen and company juggle the unpleasant task of normalizing rates in an environment filled with uncertainties (including tax reform, trade, infrastructure spending, and the implications of plunging oil prices, even as OPEC and Russia work together to cut back on production).

The pattern we've noticed in recent months is resistance coming into play in the weeks immediately following a Fed rate hike (mid-December 2016 and mid-March this year), in addition to the fact that before two of the past three meetings, the SPX was trading in the same area as the previous meeting.

On Feb. 1, the Fed met but did not raise rates, and the SPX rallied soon after. Are we on the verge of a post-Fed rally like February, since the Fed did not raise rates?  Or, are investors more focused on the fact that June rate hike probabilities jumped higher after the Fed statement, which read as follows:

"The Committee views the slowing in growth during the first quarter as likely to be transitory and continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace."

In the short term, the SPX 2,385-2,390 and SPY $238-$239 areas are key levels to watch, as they coincide with recent Fed decision days. With investors currently weighing disappointing first-quarter growth against the perception that the Fed could hike rates when it meets in June, you may see continued hesitancy to bid stocks significantly above these levels.

spy daily price chart 0506

Moreover, traders may view the SPX and SPY as having little upside from a chart perspective, with SPX 2,395.96 and SPY 239.78 representing the March 1 closing highs -- plus, the round SPX 2,400 mark looms just overhead, too. It might take a steady dose of stronger-than-expected economic data for stocks to sustain a move above the resistance levels stated above. Friday's better-than-forecast payrolls report was a start, as the SPX closed above both its all-time closing high on March 1 and the March 15 "Fed day" close for the first time since that meeting. However, it remains below 2,400.

The 2,400 level on the SPX coincides with the SPY 240 strike, which is home to more than 400,000 call contracts in the standard May expiration series that's slated to expire in less than two weeks. This is the largest build-up of calls at any one strike since October 2016, when around 500,000 calls were situated at both the 232 and 234 strikes while the SPY was trading around $215-$216.

Coincidentally, or perhaps not coincidentally, stocks struggled during that month. Whereas in October the heavy call strikes had little chance of acting as a magnet, given they were so far out of the money with little time until expiration, this time around the 240 call strike could act as a magnet, with only two weeks until expiration.  If the SPY $240 level is taken out, large open interest accumulations at the 241 and 242 call strikes represent magnets too, setting up the potential for a move to $242 (or SPX 2,420) by May options expiration.

But the longer SPY remains below $240 during the next two weeks, the more vulnerable it is to the unwinding of long positions related to the out-of-the-money call strikes discussed above.

spy may 240 call strike

"Additionally, the energy sector is a group to avoid, as it is overcrowded and underperforming... as we move through earnings season, option prices will become less expensive, which means you can once again use calls as a stock-replacement strategy. This method allows you to commit fewer dollars to the stock market, but still participate in leveraged upside if the intermediate- and longer-term uptrends in the market continue to trump the underlying risks."
    -- Monday Morning Outlook, April 24, 2017

Hopefully, you took our advice from a couple of weeks ago, and took action to avoid energy stocks, which have plummeted along with crude oil prices. Although this group could be ripe for a bounce after a bullish "key reversal" day in crude prices, continue to avoid this sector if you are an investor. Moreover, we are seeing option premiums on individual equities plummet since we have moved through the heart of earnings season, making call options an excellent way to play the uptrend in the equity market amid the perceived headline risks.

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