The S&P Volatility Extreme That Could Signal Another Sell-Off

Ahead of VIX options expiration, SPY is still staring down a formidable wall of call options at the 255 strike

Senior Vice President of Research
Oct 16, 2017 at 8:50 AM
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"...[T]here 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... If the call sellers at this strike choose to stay pat, the 255 level will act as a lid, from purely an options perspective..."

    -- Monday Morning Outlook, October 9, 2017

Earnings kicked off last week, with big-cap financials leading the charge. The earnings reactions were nothing to write home about, but that didn't impact the broader market, with the SPDR S&P 500 ETF Trust (SPY - 254.95) carving out new all-time highs again -- although the gains were measured in inches, not feet. Small-cap stocks, as measured by the Russell 2000 Index (RUT - 1,502.66), drifted slightly lower, as the round 1,500 level would not be left behind too easily. Likewise, the Dow Jones Transportation Average (DJT - 9,936.22) experienced another failure at 10,000, after its first-ever close above this millennium level on Thursday.

The S&P 500 Index (SPX - 2,553.17), while grinding out new highs, appears to have hit a wall at the 2,550 half-century mark. This follows the rally that began in late September after two weeks of similar sideways action in the vicinity of the 2,500 century mark. Long-time readers of this weekly commentary know to pay attention to half-century marks on the SPX, as they have historically acted as major hesitation and/or pivot points. In fact, from June through early September, the SPX's 2,450 level proved to have major significance, as the index danced around this area for weeks.

It has only been several days since SPY 255 and SPX 2,550 have flexed their muscles, but the sideways action in this area has been quite noticeable, and could be aided by the call wall at the SPY 255 strike that I discussed last week. A significant amount of open interest at this strike was opened by premium sellers, and this tends to have a volatility-dampening effect -- unless the opening call sellers panic.

As of now, when combining this week's standard October expiration with next week's 10/27 weekly expiration, the total SPY call open interest is still hovering around 200,000 contracts (just as it was last week, when we combined the now-expired 10/13 weekly SPY options with the standard October expiration series). This implies no evidence of panic among call sellers, who could help ignite a burst through the 255 strike if they bought back their sold 255-strike calls.  

spy open interest by strike - 255 call wall

Therefore, the market finds itself in the same situation as last week -- prone to the SPY 255 strike acting as resistance, unless sellers of the calls at this strike panic and close their positions.  In fact, note in Friday's action how the SPY spent most of the day just above the 255 strike, only to close out the week below this level.

spy 10 minute chart with 255 level

Speaking of dampened volatility, for the second time since early August, the 20-day historical volatility on the SPX has slipped below a very unusual 4%. When this occurred in early August, the SPX went on to decline by just over 2% from its closing high of 2,480 on Aug. 7 to its closing low of 2,425 on Aug. 18, with a 44-point drop occurring in the final three days of expiration week.  If another 2% percent pullback occurs, the SPX would be trading back to the round 2,500 strike -- which is a potential support level we discussed last week.

spx daily with 20 day historical volatility

While on the topics of volatility and expiration, note that the expiration of options on October CBOE Volatility Index (VIX - 9.61) futures occurs this Wednesday morning. Even amid the various VIX pops we have witnessed over the past couple of years, I have noticed that it is not unusual for 90% or more of VIX call options to expire worthless, even in months where there was a huge jump in volatility. Jumps in volatility tend to occur after VIX expirations, followed by a mean-reverting move lower ahead of the next expiration.  

With October VIX futures coming into the week at 10.33, I would not be surprised to see a Wednesday morning settlement price below 13, which really isn't going out on a limb. Our data suggest that the big put open interest at the 12 strike was sold to open, so put sellers here are on the hook if October VIX futures settlement is below 12.00 on Wednesday morning. The greatest risk of a volatility pop occurs after the October calls expire, some of which could be hedges to the record net short position on VIX futures.

vix october options open interest by strike

There have been two encouraging signs for bulls when looking at the trends in short interest and price action. The first is that, during a build in short interest on SPX components, equities shrugged off the increased shorting activity in a sign that there was a strong underlying bid for stocks.

In the most recent short interest report, there was finally a tick lower, after a relentless surge in recent reports. This decline in short interest is occurring from around the same level as what we saw prior to the November 2016 elections. I cannot say for certain whether the shorts will continue to cover -- but it does appear that many are playing a losing game, which increases the probability of short covering. Considering how the SPX behaved as it fought headwinds from a build in short interest, just think of its capabilities if the short-selling headwind turns into a short-covering tailwind.

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