3 Reasons SPY 250 Could Be Crucial Support

Heavy call open interest at the SPY 255 strike could act as a short-term lid for stocks

Todd Salamone
Oct 9, 2017 at 8:37 AM
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"[L]ast week's SPY breakout above $250 -- which is equivalent to SPX 2,500, and coincides with SPY's Sept. 20 ‘Fed day’ close at $250.06 -- paves the way for a continuation of a pattern we have seen for most of this year. That is, Federal Open Market Committee (FOMC) meetings where members vote to stand pat on interest rates have typically been followed by bullish price action.

"One source of fuel to sustain a rally, or at the very least contain pullbacks, is short covering. I continue to be impressed with the fact that, even as the shorts continue to add to their positions on components of the SPX, RUT, and PowerShares QQQ Trust (QQQ - 145.45), these equity benchmarks continue to carve out new highs."

    -- Monday Morning Outlook, October 2, 2017

If you are a bull, you are happy with the way equities began the fourth quarter of trading, as the SPDR S&P 500 ETF Trust (SPY - 254.37) continued the momentum higher that began in the final days of September. The SPY traded higher in each of the first four days last week, as did the tech-heavy PowerShares QQQ Trust (QQQ - 147.66). The small-cap iShares Russell 2000 ETF (IWM - 150.05) rallied strongly on the first day of the quarter, but flattened out the rest of the week as the index it tracks, the Russell 2000 Index (RUT - 1,510.22), struggled to make a convincing move above the round 1,500 level.

But the beat goes on, as equity benchmarks such as the S&P 500 Index (SPX - 2,549.33), Dow Jones Industrial Average (DJIA - 22,773.67), and Dow Jones Transportation Average (DJT - 9,886.88) carved out new all-time highs. 

For those of you who take notice of round numbers: After a mid-week touch of 10,000 for the first time ever, the DJT pulled back about 1 percentage point to close the week. The 10,000 level on the DJT also coincides with a round 10% year-to-date gain for the index.

Speaking of round numbers, crude oil slipped back below $50 per barrel on Friday, after a late-September move above it and four consecutive days in which $50 held as support. Despite individual sectors such as transports and energy dealing with round numbers, and the RUT battling 1,500, the SPX comes into the week well above 1,500.

After last week discussing the impressive price action among various equity indexes amid headwinds from short sellers building positions on various index components back up to pre-election 2016 levels, the excerpt below from Reuters strikes me as more evidence that there is still caution with respect to the trajectory higher in equities. Such caution represents buying power, whether it be the shorts buying positions back or fund players moving cash into equities. The latter possibility seems particularly likely, given this statistic:

"Fund investors snorted at record U.S. stock prices during the latest week, pulling the most cash from domestic equities since August, Investment Company Institute (ICI) data showed on Wednesday.

"Domestic equity funds posted $9.3 billion in withdrawals during the week ended Sept. 27.
.."

    -- Reuters, October 4, 2017

This week marks the beginning of earnings season, with financial names such as JPMorgan Chase (JPM), Citigroup (C), Bank of America (BAC), and Wells Fargo (WFC) likely to be most in focus. After a week in which Fed officials again hinted at a December rate hike, we'll hear the latest inflation data at both the producer and consumer level, in addition to retail sales numbers at the end of the week. As investors digest these various earnings and economic reports, we will be monitoring the SPY's behavior as we move into the two-week window ahead of standard options expiration -- which is when heavy open interest at put and call strikes sometimes begins to exert an extra influence by exacerbating a directional move driven by a catalyst.

As you can see on the graph below, there is a potential call wall at the SPY 255 strike, with roughly 25% of the total call open interest contained in the weekly 10/13 series, and the balance in the standard October expiration series. From what we can tell, the open interest is made up of both buy- and sell-to-open activity.

Should the SPY get through the 255 strike, one scenario would be call sellers buying back the calls to prevent a big loss, which would add fuel to a rally. A big chunk of the calls were sold to open in late July, with the SPY trading at $247, so there is a likelihood that the call sellers are at or near underwater on their position. This suggests a move through $255 could be the catalyst that causes the sellers to buy to close the position, which would support the SPY. 

If the call sellers at this strike choose to stay pat, the 255 level will act as a lid, from purely an options perspective, as those who bought the contracts from the opening call sellers must short a growing number of S&P futures to stay neutral. 

SPY October open interest

The "lid" effect was evident beginning on Thursday last week, as you can see in the chart below. But, fortunately for bulls, the SPY has another two weeks to attempt to push through the 255 strike, which is currently the strike with the highest open interest in the immediate vicinity. In fact, I find it interesting that the first down day in six for the SPY occurred on Friday, just one day after it came close to touching the call-heavy 255 strike.

spy 30minute chart since sept 25

The SPY pulling back in the short term is increasingly possible after a doji candle on Friday, in which the open and close were around the same levels. The first obvious level of support is around the $250-$251 area for three reasons:

  1. The $250.06 level is the site of the closing level on Sept. 20, when the Federal Open Market Committee (FOMC) last met and stayed pat on rates. Long-time readers know the importance of closing levels around Fed days as potential support and resistance levels.
  2. The 20-day moving average currently sits at $250.70 and is rising. This trendline marked the low in the immediate days after the Fed met in September.
  3. The 250 strike is the site of major put and call open interest, so one would expect a lot of chopping around this strike if the SPY is trading around here as expiration nears.
The market's momentum higher implies you should continue to have a long bias, as the new highs last week may force shorts to cover -- so look for equities displaying strong price action in which the shorts are feeling pain. If you see the opportunity, with the SPY call wall immediately overhead, sprinkle some short-term put options into your current holdings on stocks you see as overbought and vulnerable.

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