Watch This Crucial Trendline Test for Small Caps

There's rarely been a better time for traders to manage risk with call and put options

Senior Vice President of Research
Aug 21, 2017 at 8:26 AM
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"... 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... relative to the 9-10 readings we experienced in the weeks prior to the current U.S.-North Korea escalation... If the SPY does rally this week, a potential resistance level is also at $245.88, which is 10% above last year's close."
     -- Monday Morning Outlook, August 14, 2017

As measured by the S&P 500 Index (SPX - 2,425.55), equities had not yet hit their trough, as Thursday and Friday's trading saw the SPX take out its Aug. 10 low at 2,437.75. But, the jury is still out as to my comments about a near-trough in place, with Friday's close around 2,425.

It was not a huge decline week over week, as early expiration-week buying was spurred on by North Korea backing off an imminent plan to attack Guam. With the SPDR S&P 500 ETF Trust (SPY - 242.71) coming into the week with heavy put open interest strikes immediately below the Aug. 11 close, Monday's buying may have been driven in part by short covering related to that put open interest.

The rally was short-lived, with the week's Wednesday SPY closing high of $246.94 just one point above the round 10% year-to-date level that I anticipated could act as resistance. Moreover, last week's intraday high was at $247.57 -- barely above the Federal Open Market Committee (FOMC) meeting day close of $247.43 on July 26, which has acted as resistance despite multiple attempts to overcome this level.

In fact, things quickly went into reverse, as fallout related to President Donald Trump's response to the events in Charlottesville, Virginia, led to the resignations of multiple CEOs on his presidential councils and a rumor that Gary Cohn, Trump's chief economic advisor, might resign. And a terrorist attack in Barcelona, Spain, fueled additional unease.

As with most options expiration weeks, news headlines can exacerbate price action, and selling begat more selling as big put open interest at the SPY 142 and 143 strikes became magnets by week's end, just as they did in the previous week's trading. Those who sold the puts, and who likely covered these positions early in the week, would have been forced to sell an increasing number of S&P futures as these strikes were approached again after market participants greeted the developing uncertainties in Washington, D.C., and Spain with selling.

That said, the week concluded with some semblance of certainty, as the White House announced it would be the last day for Steve Bannon, Trump's chief strategist -- continuing what seems to be a never-ending parade of departures among key advisors in the Trump administration.

With the July 26 Fed-day SPY close at $247.43 acting as resistance these past few weeks -- defying a recent pattern in which equities have typically rallied soon after the Fed holds rates steady -- a question moving forward is whether the 80-day moving average will be supportive again on a couple of key equity benchmarks that we track; namely, the SPX and the tech-heavy PowerShares QQQ ETF Trust (QQQ - 141.23). As you can see on the charts below, these moving averages have been significant on pullbacks since the cross above around the election. But will they continue to hold, as apparent signs of dysfunction continue in the White House?  

spx 80-day moving average 0818

qqq 80-day moving average 0818

Additionally, small-cap investors should stay in tune with the price action in the Russell 2000 Index (RUT - 1,357.79). After months of trying, the RUT failed to decisively take out round-number resistance at 1,400 and 1,410, which is 50% above the 2016 low. Now, the index finds itself more than 5% below last month's high, and just north of its 12-unit monthly moving average -- a trendline that was supportive at the pre-election lows in November, but which has forecast a period of weakness in stocks when there is a monthly close significantly below it. This trendline represents average monthly closes during the past one-year period.

A break of this trendline would leave the RUT vulnerable to a move to the round 1,300 level, which was the site of major resistance before a 27% decline that began in June 2015 and lasted until February 2016.

Also on our radar is the 2016 year-to-date close at $134.85 for the iShares Russell 2000 ETF (IWM - 134.92), which previously marked low points this year in January, March, and May. The ETF settled just barely above this level at the end of last week's trading, so small-caps enter the week with this year-to-date breakeven point very much in play.

And for what it's worth, there were various media articles during the past couple of weeks discussing some who worry that we have gone so long without a 20% pullback. But who said there hasn't been a 20% pullback in stocks since the bottom in 2009? This is nonsense, if you follow small-caps.

rut 12-month moving average 0818

"... 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.
"... 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. ... 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."

    -- Monday Morning Outlook, August 14, 2017

Using history and charts as a guide, there were few surprises last week on the volatility front, as measured by the CBOE Volatility Index (VIX - 14.26). A plunge in volatility that began Monday morning lasted into Wednesday's trough at 11.25, a level I anticipated in last week's report would mark a floor on a volatility retreat.

Monday's action was a killer for those long call options on August VIX futures, as by settlement on Wednesday morning, 90% of August VIX calls expired out of the money, or worthless. However, immediately after VIX expiration, call volume exploded, as negative headlines surfaced and VIX call players looked to quickly replace calls that had just expired, either as portfolio hedges or speculative bets.

Even though North Korea fears subsided, other uncertainties took center stage, and this may continue to contribute to elevated stock market volatility levels in the near term, relative to what we grew accustomed to in much of May through July.

Perhaps it is not a matter of coincidence that the VIX remains just below chart resistance in the 17.00 area, as major equity benchmarks discussed above tread water just above potential support levels.

Finally, as one that is intimately close to the options market, I cannot think of a better time to be utilizing options as part of your overall investment strategy. Whether it is the Federal Reserve, tensions with North Korea and/or Russia, terrorism, debt ceilings, future tax policy -- or all of the above -- many uncertainties linger. That said, the SPX is less than 2% below its all-time high with its bullish trend still very much intact, even at a time when a record number of fund managers view it as overvalued.

If you think the market is headed for a sell-off, but respect the fact that you could be early in your thinking and that the "trend is your friend," you can buy call options to manage the perceived risk. The purchase of calls allows you to reduce your dollars at risk relative to buying 100 shares of the stock. Plus, the leverage options provide gives you the opportunity to achieve significant dollar profits, even with less money at risk relative to owning a significant number of shares.  

And, through the purchase of put options, you can profit from the decline that you think could be lurking.

Finally, you can play both outcomes (a continuation of the long-term trend or a "long overdue" correction) via the purchase of calls and puts simultaneously, through strategies such as straddles and options pair trading. The benefits are many, and presently at a cheap cost, too. For example, equity option prices have imploded recently, since many companies just reported quarterly earnings during the past three weeks.

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