What's Next for VIX After Last Week's Nuclear Melt-Up

How options traders can take advantage of elevated volatility in the stock market

Senior Vice President of Research
Aug 14, 2017 at 8:46 AM
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"... with the Dow at a key millennium level representing double the resistance that was in place for years during the 2000 topping process, coincident with the SPX lodging just below a half-millennium mark, this is something to put -- and keep -- on your radar for now. The sentiment backdrop suggests that there is a lower probability of this ending badly, as it did in 2000 when the DJIA was fighting a millennium mark coincident with the SPX trading below a key half-millennium level.

"...Turning to the short term, it is noticeable that the SPX and SPDR S&P 500 ETF Trust (SPY - 247.41) have been turned back at their respective July 26 closes of 2,477 and $247.45. July 26 is the day that the Federal Open Market Committee (FOMC) met and did not raise rates. The pattern during the past several months is that 'Fed day' closes usually mark resistance in the weeks after a rate hike. These resistance levels were then broken after meetings in which the Fed held pat... if you are one to err on the safe side, you should await a close or two above the levels mentioned above as further indication that the bullish pattern that has developed after no-action Fed meetings will continue."

    -- Monday Morning Outlook, August 7, 2017


"'They should be very nervous, because things will happen to them like they never thought possible, OK?' Trump told reporters Thursday in Bedminster, New Jersey. 'He's been pushing the world around for a long time,' referring to North Korean leader Kim Jong Un.

"Trump stood by his threat Aug. 8 to bring down 'fire and fury' on North Korea, saying that the statement maybe 'wasn't tough enough.' He declined to rule out a preemptive strike on Pyongyang, saying, 'We'll see what happens.'"

    -- Bloomberg, August 10, 2017

During the past couple of weeks, round numbers and "Fed resistance" have been topics of discussion, with the Dow Jones Industrial Average (DJIA - 21,858.32) probing 22,000 -- double a multi-year (from 1999-2006) millennium resistance area at 11,000. Moreover, the S&P 500 Index (SPX - 2,441.32) is perched just under a half-millennium area at 2,500, with a poor track record around prior half-millennium levels at 500 and 1,500.    

With assistance from a "war of words" over nuclear weapons that began on Aug. 8 between U.S. President Donald Trump and North Korean leader Kim Jong-Un further raising perceived risks in the market, this technical resistance established itself more firmly as additional sellers emerged.

Furthermore, per the bold in the Monday Morning Outlook excerpt above (emphasis newly added), one may have done well to heed the advice of the words "or two" when assessing whether the SPDR S&P 500 ETF Trust (SPY - 244.12) "Fed breakout" above July 26 resistance was for real. In fact, my "off to the races" comment that I made on Twitter was just prior to Trump's "counter-threats" to North Korea, as the SPY failed to experience a second consecutive close above $247.45, per the hourly SPY chart below.

"... $244.24 is the closing level of mid-June, when the Fed last raised the fed funds rate, plus the site of the SPY's 40-day moving average... The SPY 243 strike is put heavy, with much of the volume representing buy-to-open activity. Therefore, this strike is a potential magnet during a decline. But the good news, purely from an options perspective, is that strikes immediately below the 243 strike are not as put heavy, and thus they are less apt to act as magnets. Therefore, the SPY $243-$244 area can be viewed as support from multiple perspectives. These are levels to keep on your radar as we move through the next couple of weeks in these dog days of summer."
    -- Monday Morning Outlook, August 7, 2017

Above said, I find it interesting that the SPY troughed last week in the support zone I alluded to between $243 and $244. As such, with August options expiration week now upon us, this support zone is one to keep on your radar. A break of this area -- especially if it occurs early in the week -- would put the SPY at increasing risk of a move to the round 240 strike, which represents the peak put open interest in the standard August expiration series. In order for the 240 level to come into play, the 80-day moving average must give way to a pullback. The last time the SPY broke below its 80-day moving average was in mid-October, foreshadowing weakness into the election.

spy hourly chart 0812


With decent-sized put and call open interest immediately overhead at the SPY 244 and 245 strikes, there is not a directional bias around these strikes driven by lopsided put or call open interest. Also, short-covering related to expiring put open interest is unlikely in the week ahead, as the deltas on the heavy out-of-the-money put strikes are near zero -- implying that there likely isn't a lot of short interest related to this expiring put open interest. If the SPY does rally this week, a potential resistance level is also at $245.88, which is 10% above last year's close.

spy august open interest 0811


In expanding these observations beyond expiration week and the weeks since the late-July FOMC meeting, what I find most notable about the SPY is the hesitation that has occurred since SPY $245 was first touched in early June. SPY $245 is equivalent to SPX 2,450, and I have noted many times how such half-century mark levels tend to mark hesitation and pivot levels on this index.


"China won't come to North Korea's help if it launches missiles threatening U.S. soil and there is retaliation, a state-owned newspaper warned on Friday, but it would intervene if Washington strikes first."
    -- Washington Post, August 11, 2017

With the market reacting to the North Korean news as it did, and volatility levels surging last week, as measured by the CBOE Volatility Index (VIX - 15.51) and VIX futures (particularly the front-month contract), I'll use the remainder of this week's commentary to share my thoughts on this topic.

First, when I think of nuclear threat tensions rising between two countries without a missile being launched, the 13-day Cuban Missile Crisis of October 1962 comes to mind for historical reference. The Dow suffered about a 5% setback in the immediate days after the crisis began, but had rallied back to its mid-month levels by the time the crisis ended on Oct. 28. The endpoint was marked by Soviet leader Nikita Khrushchev agreeing to remove nuclear warheads from Cuba.

Can we expect Kim Jong-Un to back down, as Khrushchev did? Doubtful -- not in the immediate days ahead, anyway. If he decides to back down, we will likely never know, but simply be left wondering when the next threat comes. So, whereas there was an endpoint to the Cuban Missile Crisis, the current threats from North Korea may linger, and an "endgame" is likely nowhere in sight -- which could keep volatility elevated, relative to the single-digit VIX readings we saw recently. It is also doubtful that the U.S. will initiate a strike based on threats only, as China is a wild card in this crisis -- telling North Korea it's on its own if strikes the U.S. first, but also warning it will intervene if the U.S. were to strike first.

If you believe that "mutual assured destruction" (MAD) saves the day, whereby both countries truly believe no one wins in a nuclear conflict, last week's sell-off should be viewed as a buying opportunity. Some credit this MAD concept to explain why neither the Soviets nor the U.S. started a nuclear war 55 years ago.

At the onset of the Cuban Missile Crisis in 1962, the bears were in control, with the SPX down more than 20% from its 1961 close through September of that year, and below all longer-term moving averages. The height of the 1962 crisis marked a near-trough ahead of a massive rally that was about to follow.

With the bulls currently in control, and backwardation in the VIX futures market typically marking an end (or near end) to volatility peaks over the past several years, we are likely near or at a trough with respect to the equity pullback. That said, any perceived potential that North Korea is willing to act alone and display physical aggression toward the U.S., specifically the territory of Guam, should keep the VIX elevated. And by "elevated," I mean relative to the 9-10 readings we experienced in the weeks prior to the current U.S.-North Korea escalation.

In summary, with the looming threat fresh on the minds of investors, volatility historically low and a big short position to be unwound in the VIX futures market, I'm thinking the U.S.-North Korea crisis will prop up volatility levels. Therefore, the cost of portfolio protection will remain high in comparison to the levels during most of May, June, and July.  

With respect to the VIX, I find it interesting that Friday's high was 17.28, short of 17.68 -- double last month's intraday low of 8.84. Moreover, Thursday's close of 16.04 was just 0.08 point above this year's previous closing high of 15.96. A VIX close above 17.68 would likely hint at higher volatility immediately ahead. However, if volatility retreats in the short term, look for the 11.25 level -- half the pre-election closing high -- to be supportive. I expect that retreats in volatility will be viewed as a good opportunity to buy protective puts on equity index options and/or cover short volatility positions.

Finally, August VIX futures options expire Wednesday morning. If you follow me on Twitter, you are fully aware that in most instances, 90% of VIX call options expire worthless, even after periods in which a volatility pop occurred before expiration. Nothing in trading is a "slam dunk," but if you are one to rely on history for guidance, you could expect a Wednesday morning VIX settlement below most or all of the heavy call strikes in the August series. But beware that, to the extent these calls represent equity portfolio hedges or hedges to a short volatility futures position, there is the chance that expired calls will be replaced (or short volatility futures positions covered) with the passing of August VIX expiration, potentially driving volatility higher into the end of expiration week.

vix august open interest 0811


U.S. and North Korean leaders will most likely continue to volley words, not missiles.  Based on this scenario, there is not much more additional downside in equities, but there is also a lot of overhead resistance during a traditionally weak seasonal period. Take advantage of higher volatility to sell index premium or equity premium on individual stocks with well-defined support and resistance areas. The SPX is likely to trade sideways in the area of $245, which is equivalent to the 2,450 half-century mark on the SPX.

A less likely scenario, but one that warrants keeping on your radar, is that this crisis unfolds in a way very much unlike the Cuban Missile Crisis -- just as the SPX and DJIA stall at major half-millennium and millennium marks, which likewise occurred as stocks peaked in 2000. However, the technical backdrop has not deteriorated nearly enough to suggest bear-market risk has grown relative to last week.


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