Panic-Selling, Volatility Among Risks of Dog Days of Summer

Amid choppy post-Fed action in SPX and SPY, the risk of a volatility pop is higher than usual

by Todd Salamone

Published on Jun 26, 2017 at 8:47 AM
Updated on Jun 24, 2020 at 10:16 AM

"If the pattern in this rate-tightening cycle continues, I would expect the SPX's 2,438-2,440 area to act as resistance, or a 'hesitation' area, until the next policy decision on July 26. While 2,438 marked the Fed day close, the 2,440 level was the site of the Tuesday high close just ahead of last Wednesday's policy decision. Note that these levels are situated not far below another potential resistance point -- the 2,450 half-century mark. For SPY followers, based on closing data on the same dates, the levels to watch are 244.24 to 244.55."
    -- Monday Morning Outlook, June 19, 2017

Below is a chart that regular readers are all too familiar with, as it has been a topic of discussion for the past few weeks. I am presenting it again because in the first full week of trading after the Federal Open Market Committee (FOMC) hiked its benchmark interest rate on June 14, the potential resistance area that we pointed out on the S&P 500 Index (SPX - 2,438.30) and SPDR S&P 500 ETF Trust (SPY - 243.13) came into play at the start of last week's trading.

Specifically, since the current rate-hike cycle began in December 2015, the SPX and SPY have had short-term difficulty overtaking their closing levels from around the time of each rate hike. This pattern is clearly visible in the first chart below, which captures the mid-December 2016 rate increase and the mid-March hike.

The second chart below zooms in on the SPY's price action last week -- which was a powerful Monday run-up to the area of the FOMC day close, followed by a quick rejection at these levels as market participants continue put a lid on prices in the immediate days and weeks following a rate hike.

spy daily with fed rate hikes 0624


spy 10 minute chart June 16-23


"A sideways grind, with a milder drawdown and resistance in the SPY $244-$245 area into the next Fed meeting in late July, would be considered a best-case scenario... The SPY bottom in late March/early April was at a 61.8% Fibonacci retracement of the close in early February, when the FOMC met and did not raise rates, and the mid-March rate hike. If equities repeat the Fibonacci pattern that followed the March rate hike, support would be in the SPY $240-$241 zone."
    -- Monday Morning Outlook, June 19, 2017

The scenario excerpted above from last week's report derives from the price action in the weeks following the past two FOMC decisions in which the fed funds rate was raised. The action can be best described as "choppy, with minimal drawdown." Moreover, even when not taking into account the Fed's most recent decision, the SPY $245 area -- equivalent to SPX 2,450 -- is the site of a "call wall" when glancing at the SPY open interest configuration on quarterly options that expire this Friday. In fact, the overhead calls could be a headwind for the SPY this coming week, as long equity futures positions associated with these calls are likely to be liquidated as quarterly expiration approaches.

spy call wall 0624


Finally, SPY $245.88 is a significant level from one more perspective, as it represents a round 10% year to date (YTD) gain. Such round-number YTD gains historically mark short-term pivot levels or hesitation areas on major exchange-traded funds, and even individual equities when a company-specific catalyst is not in place.

For instance, the decline earlier this month in the PowerShares QQQ Trust (QQQ - 141.24) occurred as the exchange-traded fund was trading around $142, or 20% above the 2016 close. Going into today, while the QQQ has recovered somewhat from the sell-off earlier this month, it remains below the key $142 level. Furthermore, to reinforce the importance of round YTD percentage gain levels, the technology-heavy QQQ stalled in the $130 area -- 10% above last year's close -- from late February through mid-April.

Bulls should also be open to corrective behavior as we enter the dog days of summer, as the SPY did experience a 10% setback that began two weeks after the mid-December 2015 rate hike (the first in the current tightening cycle). But as we mentioned last week, the round $240 level on SPY is a support level that would have to be broken first, as this is the area of a 61.8% Fibonacci retracement of the gains that occurred between the February meeting, when Fed stood pat, and the $244-$245 zone.


Last Wednesday marked an event not on many traders' radars -- the expiration of standard June options on the CBOE Volatility Index (VIX - 10.02). Call open interest on VIX futures dropped from 8.9 million contracts to 5.8 million contracts as a result, so we head into the last week of the second quarter with a relatively low number of outstanding VIX call contracts.

Some of these call positions could be hedges to short VIX futures positions and/or long equity portfolios, so VIX expirations carry importance when there is an extreme short position among large speculators. This is the case now, per the weekly release of the Commitments of Traders (CoT) report. Without a hedge in place, those short volatility futures and/or long equities and who are normally hedged are more apt to panic-sell equities or cover short volatility futures positions if there is a headline that sparks downside movement in stocks.  

Plus, as many of you know by now, large speculators on VIX futures have had a noticeably poor track record in timing volatility. Therefore, given their positioning at present, a volatility surge might be considered a higher probability than normal, especially on the heels of the FOMC meeting earlier this month.

cot large spec vix futures 0624


"The energy sector's vulnerability is related mostly to what is happening in the oil futures market, as crude prices continue to decline -- yet large speculators, per the weekly CoT report, are S-L-O-W-L-Y unwinding long positions. Per the chart below, there is still significant potential for further unwinding of these long positions, which could negatively impact stocks in the energy group."
    -- Monday Morning Outlook, June 19, 2017

"Energy stocks dive again as oil drops, offsetting tech and healthcare"
    -- L.A. Times, June 21, 2017

If the SPY mounts a strong rally above the $244.50-$246 area before the next FOMC meeting in late July, it would be a major change in its short-term behavior relative to its action following four separate rate hikes since December 2015.

While the short-term outlook is not exactly a rosy one for index investors, the good news is that there is opportunity on both sides of the market for traders. Sectors such as healthcare, leisure, defense/aerospace, and technology are rallying, while energy stocks continue to slump. Energy is a sector that I've highlighted as having major vulnerability since late April, a period in which the Energy Select Sector SPDR Fund (XLE - 64.38) has declined by more than 6%.

Continue to utilize call options to play your favorite equities. Avoid the energy space unless you are betting against the sector,  as I have not yet seen evidence that those holding out hope for a rebound in crude prices have thrown in the towel -- which they'll likely do when the bottom is near.

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