Don't Overlook This VIX Seasonality Risk

Options traders should keep an eye on implied volatility levels as earnings season approaches

Senior Vice President of Research
Jul 3, 2017 at 8:40 AM
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"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

A theme that I have repeated over the past several weeks is the uninspiring price action in the immediate weeks following a rate hike -- a phenomenon that has been a constant since the Fed began its tightening cycle in December 2015. Look at a chart with markers showing where a Federal Open Market Committee (FOMC) rate hike occurred, and you can see resistance coming into play around the levels where stocks were trading at the time of those FOMC meetings. You have seen such "proof" in the charts that have accompanied these commentaries for weeks.

A potential scenario that I painted on the Monday following the last rate hike has come to fruition in the two weeks after the meeting, with resistance coming into play for the SPDR S&P 500 ETF Trust (SPY - 241.80) in the $244-$245 area -- site of the pre-FOMC meeting day close, as well as the Fed day close itself.

Moreover, last week's low occurred at the round 240 strike. We identified this as a potential level of support, given that it's a round number and corresponds with a 61.8% Fibonacci retracement of the rally that occurred between the early May FOMC meeting, when policymakers held rates steady, and the mid-June meeting, when the committee raised the fed funds rate for the third time in six months. The 240 strike was also home to the biggest put open interest in the immediate vicinity of the SPY for quarterly options expiring this past Friday.

spy fed resistance 0630

Therefore, even as we enter a fresh new month and quarter with a holiday-shortened week, the risk is a pattern that has been clearly evident in past months and quarters repeating itself again, with stocks grinding sideways-to-lower until the next FOMC decision. If past is prologue, do not expect equities to make any meaningful headway until after the July 26 FOMC meeting, as fed funds futures traders are pricing in only a 2.5% chance of another rate hike, and rallies have tended to occur following FOMC meetings when the Fed stays pat.

"A series of speeches from Fed officials Tuesday indicated a wariness about asset bubbles and hinted that the Fed may tighten monetary conditions even if key economic signals remain subdued...  Federal Reserve Vice Chairman Stanley Fischer pointed to rising stock valuations, thin corporate bond spreads and ultra-low readings on the CBOE Volatility Index as signs of increased risk-taking."
    -- The Wall Street Journal, June 28, 2017

"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...  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...  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."
    -- Monday Morning Outlook, June 26, 2017

The pullback in the stock market has been mild since the Fed meeting, but it is fair to say that volatility exploded, if only for a brief period, in Thursday's trading. Per the chart below, after creeping higher from the 10.00 area on Tuesday and Wednesday, the CBOE Volatility Index (VIX - 11.18) found itself just above 15.00 in Thursday morning's trading, or roughly 50% above the prior week's close around 10.00. The intraday move to 15 was last week's peak, and has been an area of resistance in the first half of 2017.

vix 30 min 0630

We witnessed this latest VIX explosion as the typically "wrong way" large speculators in the weekly Commitments of Traders (CoT) report were in an extreme net short position on VIX futures. The good news for bulls is, by Thursday's close, the VIX was at 11.44 -- just below the 11.50 level, or one-half the 52-week and pre-election highs. Plus, 11.50 also represents a VIX decline of 20% in 2017. If the VIX closes above 11.50, there would be heightened risk of a VIX pop to the 18.75-19.50 area, which is double the May-June intraday and closing lows.

While on the volatility topic, I asked Schaeffer's Senior Quantitative Analyst Rocky White to create a graph that displays the typical behavior of the VIX throughout the year. He did this by looking back to 1990 and calculating an average and median year-to-date return for the VIX from January through December.

The VIX typically hits its year-to-date lows around the middle of July, before bursting higher into the months of August into October. This could be an appropriate "seasonality" note, especially within the context of large speculators on VIX futures holding an extreme short position.

average vix since 1990

The technical backdrop continues to be impressive, so do not ignore the long side, even as I point out potential risks lingering. As I've been saying for months, you can use call options to reduce your risk but still maintain exposure to continued upside. If you are using call options on individual equities, pay attention to how much you are paying; August options are likely the most expensive, as earnings season is at its busiest in between July and August expirations. Consider several expirations, including weekly options that fit your time frame, and pick the option that gives you the best deal from an implied volatility perspective.

The energy sector is still one to avoid, despite its bounce last week. Many notable banks reduced their target price forecasts for oil, but these downward revisions largely just reflected the sell-off in crude oil that they did not anticipate. The bottom line is that there are still many energy bulls that are underwater and in "hope" mode.

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