Why Wednesday's SPX Close Will Be Key for Stocks

A Wednesday rate hike from the Fed would make that day's S&P 500 close a key level for the stock market

Senior Vice President of Research
Jun 12, 2017 at 8:35 AM
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"... 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)...   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... "
    -- Monday Morning Outlook, June 5, 2017

We head into June options expiration week -- featuring a Wednesday policy statement from the Federal Open Market Committee (FOMC) -- in the wake of a selling surge on Friday afternoon that pushed major equity exchange-traded funds (ETFs) below key areas I discussed last week.

Specifically, after a close above the $142 level on the first Friday in June, the tech-heavy PowerShares QQQ Trust (QQQ - 139.98) retreated significantly below this level last Friday. I view this level as important because $142 is the site of the last significant call open interest strike in the June expiration series. Moreover, $142.26 is 50% above last year's closing low and 20% above the 2016 close -- round-number returns that may create hesitation among would-be buyers, and/or spark selling among those seeking to lock in some profits.

And the SPDR S&P 500 ETF Trust (SPY - 243.41) hit an intraday all-time high of $245.01 on Friday, before a nasty reversal sent it back below the previous week's close. For candlestick followers, there were two "doji" candles during the week -- representing trading days in which the open and close are the same (or nearly the same). Such candles are sometimes indicative that a trend reversal could be at hand.

Those SPY doji candles could be worth paying close attention to, as this potential reversal signal occurred just below the last call-heavy 245 strike and ahead of a Fed meeting this week. Plus, the SPY $245 region coincides with the 2,450 half-century mark on the S&P 500 Index (SPX - 2,431.77) -- and long-time readers of Monday Morning Outlook are fully aware of the historical significance of these half-century mark levels, which often serve as key pivot points or "magnets" in which sideways action occurs over a lengthy period.

spy june options open interest by strike 0609


"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.
  
 -- Monday Morning Outlook, May 8, 2017

"... 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."
  
 -- Monday Morning Outlook, June 5, 2017

Along with 2,450, another yet-to-be determined SPX level could also become important in the days and weeks ahead, following the Wednesday FOMC meeting. As I pointed out early last month and repeated last week, the SPX closing levels on Fed rate hike days during the current tightening cycle have marked resistance in the immediate days and weeks following the meeting. Also, in recent months, the market has rallied in the absence of a rate hike (see chart below).

With fed funds futures indicating a 99.6% chance of a rate hike, according to the CME Group website, there is a good chance this Wednesday's SPX close could prove significant in the weeks ahead.

The graph below suggests that the Fed could continue to be of utmost importance to U.S. stocks, with political drama in Washington, D.C., and the European Union (EU) providing background noise. It might also suggest that investors are not exactly welcoming rate hikes, as growth concerns remain, and uncertainty lingers with respect to tax reform, healthcare reform, infrastructure spending, and the end of the Dodd-Frank era.

spx on fed rate hike days 0609


"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."
    
-- Monday Morning Outlook, June 5, 2017

The CBOE Volatility Index (VIX - 10.70) printed as low as 9.37 in Friday's trading -- but during the afternoon sell-off, VIX hit an intraday high of 12.11, which is in the vicinity of the 11.25-12.88 area I've been watching recently. (While 12.88 is half the June 2016 closing high of 25.76, 11.25 represents half the November pre-election closing high of 22.50.)

The VIX will likely remain elevated into the Fed's decision and subsequent briefing on Wednesday. Beware of any sub-10 VIX readings going into or immediately following the FOMC meeting, as short-term volatility spikes have followed VIX closes below 10 over the past couple of months.

It's also worth noting that standard June options on VIX futures do not expire until June 21, so there will not necessarily be any additional demand for VIX calls to help put a floor on volatility levels this week.

However, per the chart immediately below, the Commitment of Traders (CoT) report shows large speculators on VIX futures -- who have been wrongly positioned ahead of major volatility moves -- are again in an extreme short position on volatility index futures. This would suggest to contrarians that the risk of upside movements in volatility exceed the downside reward, so longs should take precautions to guard against adverse, short-term moves in the equity market that help generate a volatility spike.

cot large spec vix futures 0609


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