SPY Is Overbought Again, But With One Key Difference

In the face of Friday's opening gap higher, those SPY 255-strike call sellers finally blinked

Senior Vice President of Research
Oct 23, 2017 at 8:23 AM
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"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...

"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."

    -- Monday Morning Outlook, October 16, 2017

Two weeks ago, with standard October options expiration around the corner, I put the heavy call open interest at the SPDR S&P 500 ETF Trust (SPY - 257.11) 255 strike on your radar. Data we receive from the major options exchanges suggested that many of these calls were sold to open, implying option sellers had sold away any upside above the $255 level.

Another way of saying this is that the SPY was "pre-sold" at 255, suggesting this area would prove difficult to move through up until expiration. In the options market, sold options at a strike tend to be volatility-dampening -- and as you can see on the 10-minute chart of SPY below, there were multiple touches of the 255 strike from Oct. 9 through last Thursday.

It wasn't until Friday morning -- coincident with standard October options expiration, and following two consecutive daily SPY closes just above $255 -- that those SPY 255 call sellers finally blinked. Well-received legislative progress on a pro-business tax plan prompted an opening gap higher, and those who "pre-sold" SPY at $255 suddenly found themselves holding the bag as the ETF rallied away from this level.

spy 10 minute chart with 255 strike

The SPY has now been in "overbought" territory since the beginning of the month, as measured by its 14-day Relative Strength Index (RSI). The last time it moved into overbought territory was the beginning of June, with a close call occurring in mid-July. In June, sideways movement with a downside bias ensued for more than a month. This time, we're seeing sideways movement with an upside bias.

spy with 14-day rsi

Perhaps the key difference between these two periods is that, in June, the shorts were building positions on S&P 500 Index (SPX - 2,575.21) components. But the most recent short interest report suggested the shorts are in covering mode, after building the largest position since the uncertainty surrounding the 2016 election. A crucial similarity between both periods is that the sideways action when SPX was in or near an overbought condition occurred at $245 and $255, which is equivalent to the 2,450 and 2,550 half-century marks on the SPX.

spx component short interest oct 2017

Coincident with the SPY 255/SPX 2,550 drama playing out, the Russell 2000 Index (RUT - 1,509.25) began October at the round 1,500 level, and it has stayed in this area. This century mark has been on our radar in recent weeks, as previous such milestones have been giant speed bumps for RUT during this bull market. The exception would be RUT 1,100, which was a short-lived battle when it moved above it in October 2013, only for this round number to be revisited as a support area on multiple occasions through the mid-point of last year.

Bulls would like to see the RUT defy history and put some distance between itself and 1,500 in a hurry. Time will tell, but this is something to watch in the days, weeks and maybe even months ahead after a hurried move to this level from 1,400.

rut weekly chart with century levels

"...note that the expiration of options on October CBOE Volatility Index (VIX) 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."
    -- Monday Morning Outlook, October 16, 2017

I can't help but end this discussion with some notes on volatility measures. Last Wednesday morning's CBOE Volatility Index (VIX - 9.97) settlement price was 10.53 -- so, like clockwork, a huge majority of call options expired worthless. In fairness, to the extent that these are hedges, most buy far out-of-the-money calls (a) to keep hedging costs low and (b) because they are protecting against a huge decline in stocks that might see the VIX advance by 50-100%.

And, as CNBC senior markets commentator Michael Santoli said in reply to my tweet above, "At least they provided their owners with a psychological hedge before they went 'permanently out of the money'."  After reading this, it reminded me of the caution that has been prevalent in this bull market, due to the multitudes of headline risk that we read and hear about almost daily. Whether these are hedges to the huge short VIX futures trade or a long stock portfolio hedge, headline risks have been sufficient to prevent the kind of euphoric atmosphere that is prevalent at key market tops.

Just two days after the expiration of standard October VIX options, the VIX saw a minor pop from Wednesday's close of 10.07 to Thursday morning's intraday high of 11.77. This "pop" was very short lived, with the peak taking place at roughly half the 52-week high of 23.01.

Finally, in case you missed the commentary posted to our site last week about the extremes in 30-day SPX historical volatility, be sure to read The S&P Just Did This for the First Time in Almost 50 Years to learn the historical implications of previous lows in volatility like those we're seeing today.

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