Best Options to Buy and Sell After the Volatility Surge

Large speculators now have the highest net long position ever on VIX futures

Senior Vice President of Research
Feb 12, 2018 at 8:23 AM
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"A move below SPX 2,730 could result in the round 2,700 area being visited rather quickly. Given the sharpness of Friday's decline, I may as well mention that SPX 2,673.61 and SPY 266.86 are the site of 2017's closing levels, and the next 'line in the sand' if the levels above are taken out ... As for the bad news, the VIX closed above 16.05, which I see as key because it represents half the 2016 intraday high and is also the site of the 2017 closing high."
    -- Monday Morning Outlook, February 5, 2018



In order to understand where we could be headed, it is important to have a theory as to what drove equities to their largest weekly loss in years last week. My Feb. 5 commentary, entitled, "Read This Before You Try to Buy the Dip," spent considerable time discussing the implications of the pullback that began the week prior, when the S&P 500 Index (SPX - 2,619.55) violently turned lower from a long-overbought condition. Much time was spent considering the SPDR S&P 500 ETF Trust's (SPY - 261.50) February open interest configuration and the potential put "magnets" below the market, in addition to how I viewed the advance in volatility, as measured by the CBOE Volatility Index (VIX - 29.06).

The key SPX levels I addressed were 2,730 and 2,700, as derived from the open interest configuration on SPY, which is roughly one-tenth the value of the SPX. As you can see on the 10-minute graph of the SPX below, once the 2,730 level broke on Monday afternoon, it was only two hours later that the round 2,700 level was visited -- admittedly, much swifter than I anticipated. 

A re-test of 2,730 -- where there is major call and put open interest -- would occur later in the week, but a failure here, and subsequently at 2,700 the next morning, led to what was more delta-hedge selling, as I warned in a Thursday morning tweet (embedded above). The accompanying graph displayed major put open interest at the SPY 255 strike, at which point put open interest at lower strikes was significantly less (implying smaller magnets) until the 250 strike. The implication was that SPY 255 or 250 strikes could be targets, equivalent to SPX 2,550 or 2,500. 

spx 10min chart

This was interesting, as just below 2,550 was the SPX's 200-day moving average at 2,539, and just above 2,550 was the level that represented a 10% SPX pullback from its Jan. 26 closing high of 2,585. In a volatile market like we saw last week, the area between 2,539 and 2,585 represented potential support when combining both technical and options-related analysis. 

On Friday, the SPY 255 strike gave way, which likely led to additional selling of S&P futures among those who were short puts at this strike. Technical buying and smaller put magnets just below this strike likely allowed stocks to stabilize, as shorting of S&P futures related to open SPY puts finally began to subside as technical buyers stepped in around the index's 200-day moving average, creating a V-type rally Friday afternoon. Additionally, a trendline connecting higher lows since April 2017 is situated at the site of Friday's low.

daily spx with 200day

SPY Feb OI config

 "As for the bad news, the VIX closed above 16.05, which I see as key because it represents half the 2016 intraday high and is also the site of the 2017 closing high. That said, the close is just barely above 17.28, 2017's intraday high ... If the VIX remains above 2017's high mark, and/or takes out 18.30 -- double this year's closing low -- more trouble could be on the immediate horizon as continued demand for portfolio protection via SPX puts is likely a sign that buyers are not ready to step in and buy the dip."
    -- Monday Morning Outlook, February 5, 2018

Per the excerpt above from last week's commentary, I was concerned with the behavior of the VIX, which closed the prior week above a level that for months had acted as resistance. And by Monday, it took out another resistance level at 18.30, which became even more troubling. 

Obviously something was amiss, and this volatility surge continued, with the VIX skyrocketing more than 100% on that Monday. In the process, those long the VelocityShares Daily Inverse VIX Short-Term ETN (XIV - 5.38), which moves inversely to the VIX, got wiped out due to the explosion in volatility.

Essentially, if the CBOE Short-Term Volatility Index (VXST - 31.64) doubled in more than a day, the XIV prospectus cautioned that the XIV would close -- which will occur on Feb. 20 -- because it would wipe out its value. Many were long this fund -- an effective bet on lower volatility -- so as its closure was imminent, many short VIX futures had to be unwound, generating an unprecedented one-day increase in volatility. 

To the degree computers were taking cues off volatility, sell programs were likely tripped, causing major losses in the equity market. And as I've cautioned before, once there is a "trigger" to destabilize equities, the never-ending put open interest that builds up below the market month after month on equity exchange-traded funds (ETF), such as the SPY, can become magnets. This is likely what we witnessed as the "after-effect" of the "volatility event" last week.

daily vix chart

Certainly something spooked the market, and many are pointing to bonds, as the 10-year yield moved above 2.75% to begin the month. This coincided with the equity market sell-off, so perhaps there were computer programs set to sell stocks as yields moved through this threshold? Nonetheless, keep in mind that the equity market had advanced rather impressively since September, when yields bottomed around 2.00%. 



Back to volatility -- the Commitments of Traders (CoT) report came out on Friday and revealed massive short covering on VIX futures among large speculators, per the chart below. Remember that last year, I was constantly warning that the biggest risk to the equity market was the historically wrong-way large speculators being short volatility. 

VIX CoT chart

Well, these large speculators got burned in a big way, as the explosion in volatility led to massive short covering in VIX futures. They moved from a net short position of 59,000+ contracts to net long more than 85,000 contracts -- the biggest net long position ever! On the rare occasions when this group has gone long volatility futures, volatility has plunged. The 2017-to-early 2018 volatility risk to equity market participants may now be an opportunity for those looking for an entry into the stock market following last week's volatility event.

With the VIX in territory not seen for a long time, I am focusing on the 32.08-33.12 area, which is double the 2017 closing high (32.08) and triple 2017's close (33.12). If the VIX remains below this area, and the SPX remains above 2,550, you can emphasize the long side. Potential short-term resistance is at 2,667, which is the closing price when the Fed last raised rates in mid-December, and home to the SPX's 80-day moving average.

Also on the volatility front, it will be interesting to see where the VIX settles on Wednesday morning, when VIX options expire. If you follow me on Twitter, you know that it is typical for about 90% or more of VIX call options to expire worthless. Can the VIX make a dramatic decline below the major call open interest strikes shown on the graph below?   In fairness, more than 1 million VIX February expiration calls were liquidated last week, but nearly 4 million February VIX calls remain outstanding.

vix feb open interest

As for strategy in the days ahead, keep in mind that it is options expiration week, and if the SPY moves back below $260, the delta-hedge selling risk remains. That said, the longer SPY remains above this heavy put open interest strike, short covering becomes a possibility, as short positions related to put open interest at strikes below the SPY's value are unwound as expiration nears. 

If you are a premium seller, put sells and put credit spreads look attractive, as equity implied volatility is high, especially on shorter-dated options. Additionally, for many companies, the company-specific earnings event risk has gone away.

If you are using call options to leverage stocks' upside, consider March expiration or after, as many weekly and standard February options are expensive, even with many companies recently reporting earnings. Quite a few equity option term structures look like that of volatility futures, which is still in backwardation (i.e., shorter-term futures are more expensive than longer-term futures). 

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