Will Volatility Buyers Crash the Party for Stocks?

The equity-only put/call volume ratio suggests there's room for stocks to build on last week's strength

Senior Vice President of Research
Sep 5, 2017 at 8:49 AM
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"... even though a bounce in equities occurred last week, there is more to be done in order for the short-term technical backdrop to inflict pain on the bears. The IWM, for example, is trading just below its 200-day moving average, which acted as support in early November 2016. Additionally, it is still below the $138 level, which has acted as resistance on multiple occasions (December 2016; January, March, and April 2017).

"Furthermore, the last time the SPY went a month or longer without rallying above its Fed-day close in the absence of a rate hike was September 2016. With that said, it has now been just over a month since the July 26 Federal Open Market Committee (FOMC) policy decision. The Fed did not raise rates, but the SPY has not yet rallied above the July 26 close of $247.43."

    -- Monday Morning Outlook, August 28, 2017

Since mid-August, after we highlighted the fact that key equity exchange-traded funds (ETFs) -- specifically, the SPDR S&P 500 ETF Trust (SPY - 247.84), the PowerShares QQQ Trust (QQQ - 146.00), and the iShares Russell 2000 ETF (IWM - 140.52) -- were trading at support, stocks stabilized and have rallied impressively from the mid-August lows.

In fact, there was a little bit of improvement in the short-term technical backdrop, even though most equity benchmarks enter the week trading at, or just below, resistance. The SPY, for example, finally closed above $247.43, its close when the Federal Open Market Committee (FOMC) last met and decided to hold rates steady. For weeks, this level acted as resistance on a closing basis. That said, while the SPY barely closed above $247.43, the S&P 500 Index (SPX - 2,476.55) comes into this week's trading slightly below its July 26 close of 2,477.83.  

Moreover, the small-cap oriented IWM, after finding support around its 2016 close of $134.85 -- a support level in place on multiple tests since January -- rallied back above its 200-day moving average. The mid-August move below this popular trendline may have shaken out weaker hands. Not only did the IWM retake its 200-day moving average, but it also climbed above $138, site of multiple monthly highs since December and a trendline connecting higher lows since March. And to finish the week off, the IWM climbed above $140, which is equivalent to the round 1,400 level on the Russell 2000 Index (RUT - 1,413.57).

The RUT 1,400 area is significant not only from a pure round-number perspective, but it is also about four times the 2009 low. Since the RUT first touched 1,400 in February, it has been a sideways grind, with the index unable to move significantly north or south of this level. The RUT's all-time closing high lurks 2.6% overhead at 1,450, while April, June, and August monthly highs are just above at 1,425.

As the RUT takes on 1,400 again, another equity benchmark, the Dow Jones Industrial Average (DJIA - 21,987.56), is making its second-ever assault on the 22,000 millennium mark, after failing to hold above this level last month. On Friday, the DJIA moved above 22,000 intraday, only to close below it.

Finally, after the QQQ's hold at its 80-day moving average -- which also coincides with the site of a round 20% year-to-date gain ($142.17) -- the tech-heavy ETF pushed above $144.36, which is 50% above the 2016 closing low, and $144.87, its late-July closing high. A new all-time closing high for this ETF was also established last week when the QQQ closed Friday at $146.00, just one-tenth above the all-time intraday high of $145.90 the day after the FOMC met in late July.

Equities have fully recovered from the mid-August hiccup, even as market participants were forced to digest news early in the week that North Korea had fired a missile over Japan and into the sea. As quickly as a nuclear threat developed in the minds of investors in mid-August, such fears are now dissipating.

qqq daily 0902
Chart courtesy of StockCharts.com

Was last week's action a prelude to a breakout, or just a move to the top of the range as we head into September, a historically weak month for equities? Time will tell, but one indicator that supports a breakout, albeit a small one, can be found in the options market.

As I observed on Twitter last Thursday, the all-equity, buy-to-open put/call volume ratio is rolling over from a multi-month high, implying fear is giving way to optimism. Typically, when this happens, equities drive higher. Even with the rollover in this ratio, it is higher relative to mid-June, when the SPX first began probing the 1,450 half-century mark and I warned that such levels typically mark hesitation areas.  

There is room for the ratio to move back down to this mid-June low -- but note how the recent peak in the ratio wasn't nearly as high as in the past. This might suggest that follow-through buying from last week will be limited. This would make sense, especially with SPX 2,500 located less than 25 points overhead.

bto put call ratio 0902

"... if one is anchoring to the pre-election high of 22.51, a VIX reading that is half that level might be viewed as an attractive entry point to buy portfolio protection via SPX or SPY put options. With the recent terrorist attack in Spain, debt ceiling/government shutdown worries now mounting, and tax reform back in the headlines, some market participants may use last week's retreat in volatility as an opportunity to stock up on portfolio insurance."
    -- Monday Morning Outlook, August 28, 2017

Moving on to the world of volatility, it appeared early last week that the CBOE Volatility Index (VIX - 10.13) 11.25 level would hold, on the heels of Monday's news that North Korea was back to playing with missiles. The news sparked a Tuesday morning VIX gap up to a high of 14.34, where it peaked for the week. To my surprise, not only did the VIX decline below 11.25 on Wednesday, but it verged on another single-digit reading in Friday's trading, reaching a low of 10.02 during the session.

With the VIX at the round-number 10 level as many key stock benchmarks trade at resistance, it wouldn't be surprising to see volatility buyers crash last week's party, creating a potential headwind early this week. In the VIX futures market, Commitments of Traders (CoT) data shows large speculators were back to the short VIX futures trade, after covering throughout the month of August and again being on the wrong side of a VIX pop last month.

vix hourly chart 0902

While the landscape is littered with potential landmines for investors to navigate, it's also rife with multiple benchmarks trading at or near all-time highs, so it's difficult to sit it out and miss out on the underlying trend.

However, options are not priced as if a major move is coming. If you're worried about these "landmines" exploding, consider options as either a hedging vehicle and/or a speculative vehicle to bet on stocks you are following. You can make money betting on individual equities moving higher via the purchase of calls, and/or bet on others to move lower via the purchase of puts. Plus, you can limit your dollars at risk relative to pure equity plays, while benefiting from leverage that allows you to pocket big profits when you are correct.

Hear more from Todd in our exclusive Q&A, Options Trading Insights from the Russian Ruble Crisis, and More from the Last 24 Years.

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