The Other Stock Market Risk to Watch Ahead of the Fed

The SPY 245 call strike could act as a magnet as options expiration approaches

Senior Vice President of Research
Jun 5, 2017 at 8:53 AM
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"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)... On Feb. 1 the Fed met but did not raise rates, and the SPX rallied soon after.

"On Thursday, the SPX moved above 2,400 and established a new all-time high. This follows the lows in the previous week near the 2,350 half-century mark…The 2,350 area was also the site of the index's rising 80-day moving average and a trendline connecting the late-March and mid-April low. As you can see in the chart below, utilizing the buying pressure from this area, the SPX finally surged above a level that has been a thorn in its side since the beginning of March... With the SPX comfortably above its May 3 closing level, and no rate hike earlier this month, we may be embarking on a repeat of the post-Fed rally from February."
     -- Monday Morning Outlook, May 8, 2017

The S&P 500 Index (SPX - 2,439.07) has not taken the exact path higher it did in February following the Federal Open Market Committee’s (FOMC) Feb. 1 decision to hold rates steady. However, another post-FOMC rally is in motion, following the latest decision to stand pat on May 3. Whereas the FOMC decision to hold rates steady in February was immediately followed by an uninterrupted month-long rally, the SPX was trading above its May 3 close until the mid-May retreat -- but quickly recovered from that short retreat, carving out new all-time high territory in Friday’s trading, and finishing last week 2.1% above its May 3 close at 2,388.13.

We are now only two weeks away from the June 14 FOMC meeting and, according to the CME Group website, the current odds of a 25 basis point rate hike are 91%, based on fed funds futures prices. Just as we're seeing now, stocks stalled in early March ahead of that month's FOMC meeting, which resulted in a rate hike. 

Moreover, in the second half of March and throughout April (following the rate hike), the SPX had difficulty trading above its Fed rate-hike day close. This price behavior was similar to the price action following rate hikes in December 2015 and December 2016. In fact, it was not until July 2016 that the SPX finally made a sustained move above the Dec. 16, 2015, FOMC day close of 2,073.07 -- although the mid-December 2016 rate-hike day closing level proved to be more of a month-long hesitation point until the inauguration of Donald Trump. 

SPX chart fed meetings

Amid a likely rate hike, investors may take a wait-and-see approach in the weeks ahead, just as they did in the first two weeks of March. In early March, however, the SPX was battling the round 2,400 level, whereas now it is trading comfortably above this round-number resistance.   

With that said, and as I have observed on numerous occasions, half-century marks have proven significant too in terms of hesitation or pivot levels. Therefore, bulls would (at a minimum) like to see the SPX drift higher into the 2,450 half-century area in the days ahead. The 2,450 mark corresponds roughly with the 245 strike on the SPDR S&P 500 ETF Trust (SPY - 244.17).   

We mention the SPY 245 strike because we are entering that two-week window ahead of standard options expiration (the third Friday of the month). Standard options tend to have the heaviest builds of call and put open interest, and thus can increasingly influence stock prices as expiration gets closer.

As you can see on the SPY June open interest configuration chart below, the 245 strike is the site of the last heavy call open interest. Therefore, there is the potential for this strike to act as a magnet. Sellers of these calls will likely buy an increasing number of S&P futures to hedge as the SPY moves closer to $245, and these once far out-of-the-money options become more sensitive to changes in the underlying.  

The downside to this call open interest buildup is that if the SPY is trading in the area of major call open interest strikes (or slightly above), and a Fed hike is once again greeted with sellers the day after the decision, the SPY is vulnerable to heavy selling as long positions associated with the big call open interest are unwound, inducing more selling than normal.

SPY june open interest

From a technical perspective, I continue to be impressed with the equity market. Much has been made, at least in the media, about the rally in FANG stocks (Facebook, Apple, Netflix, Google) providing the strength behind the rally. However, I see the daily advance/decline ratio on SPX component stocks moving higher from the April and May lows and close to its 2017 highs. 

And, on Friday, the Russell 2000 Index (RUT - 1,405.39) closed above the round 1,400 level for the first time since May 1 -- but it remains to be seen whether or not it can sustain a move above 1,400, after "false” breakouts above it in February and late April. The S&P MidCap 400 Index (MID - 1,751.11) closed Friday within a chip-shot of its March 1 all-time closing high of 1,758, as it trades in the 1,750 half-century mark zone, an area it has struggled to overcome.

That said, FANG names and other big-cap tech stocks do continue to lead the charge. In fact, the PowerShares QQQ Trust (QQQ - 143.46) closed impressively above $142 on Friday -- a level that I had marked as potential resistance, as $142 is 50% above the 2016 low. Moreover, the QQQ 142 strike is the first strike in which call open interest outnumbers put open interest by a significant margin in the June expiration series.

In addition to the Fed risk two weeks from now, another risk lies in the area of volatility, as the CBOE Volatility Index (VIX - 9.75) closed below 10.00 once again on Friday. When the VIX closed below 10 on May 9, it preceded an ensuing spike to an intraday high of 16.30 on May 18, during May options expiration week.  

Moreover, per the Commitments of Traders (CoT) report that was released on Friday, the historically wrong-way large speculators crowd is at it again, shorting VIX futures. This shorting activity last week occurs after they were wrong yet again in mid-May, covering nearly one-third of their net short position during the mid-May VIX spike before re-establishing new positions since then.

You can play the strong technical backdrop and risks mentioned above by continuing to avoid the vulnerable energy group, as was stated in the May 8 edition of Monday Morning Outlook and reiterated last week. Additionally, use options to play your favorite long positions, whether your time frame is one week or several months away. With earnings season mostly out of the way, equity options are once again cheap, and they afford you the luxury of committing fewer dollars to the market (thereby limiting your dollars at risk), while still giving you the opportunity to make large sums of money as your percentage gains are a multiple of what you might get with the underlying stock.

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