"If the market is destined to chop in the days ahead, the put-heavy [SPY] 270 strike is one to watch as potential overhead resistance. Although this wasn't the case when equities rebounded from their lows early last month, often times put-heavy strikes like 270, after being broken, act as resistance on the rally back."
-- Monday Morning Outlook, March 5, 2018
Last week, I indicated that the SPDR S&P 500 ETF Trust (SPY - 278.87) was coming off the $265-$267 zone, an area that I saw as critical support in the weeks ahead. Also, I indicated that if the market were to move higher, the SPY 270 strike could mark resistance as the site of heavy put open interest, plus its 20-day moving average and a 50% retracement of last month's high and low.
But it was only hours later on Monday afternoon, with SPY trading above the 270 strike, I found myself leaning bullishly for the rest of the week in an interview with TimingResearch.com. The SPY had already moved through the 270 strike, which I mentioned on the show could set in motion the potential for short covering as we moved through the week, with standard March expiration less than two weeks away and SPY above the heavy put open interest strike.
By the end of the week, the SPY had exploded through two areas of potential resistance that I had discussed in last week's report and on Twitter. Friday's move through the second layer of resistance at $273 was driven by a bullish reaction to the February employment report, which saw more people enter the workforce -- calming inflation fears that were fanned by the January employment report released in early February, which fueled a market plunge and volatility pop.
In fact, from Monday through Thursday of last week, there was a lot of fear heading into that Friday employment number, with the impact of the January report still fresh on traders' minds. For example, front-month Cboe Volatility Index (VIX - 14.64) futures were trading higher than VIX futures with later expiration dates, a condition known as backwardation. When there is backwardation, traders are positioning for a short-term drop, and therefore bid shorter-term volatility futures higher than longer-term volatility futures. The VIX futures term structure moved out of backwardation and into a more typical contango after the market opened higher on the heels of February's employment data.
As bull markets do, equities digested perceived negative news, such as the resignation of President Donald Trump's economic adviser Gary Cohn, but rallied strongly on perceived bullish news, such as the gradual softening of of Trump's tariffs on steel and aluminum and the employment report.
"…the short-term sentiment backdrop has changed quite a bit from the optimism that was present ahead of the correction that began in late January, suggesting an increasing probability that a breakout occurs."
-- Monday Morning Outlook, Feb. 26, 2018
We have come full circle from the bullish comments I made two weeks ago, which preceded a short-lived pullback of more than 3% during the week of Feb. 26 through March 2. The SPY again comes into the week just below resistance -- this time from the late-February high, with the round $280 level, which corresponds with the S&P 500 Index (SPX - 2,786.57) 2,800 century mark, residing just above that.
The $280 level is also interesting from an options perspective, as we embark upon March expiration week. There are heavy calls at the SPY 280 strike, but most of these calls were sold to open. Since they were sold, there is a dampening effect on the underlying as it approaches that strike. This is because in order to maintain a neutral position, those who bought the calls from the call sellers will hedge by shorting S&P futures as the SPY approaches $280, thus making $280 a lid. The closer we get to standard options expiration, which usually draws the most open interest, the more of an impact the options market is prone to have when large open interest strikes are approached.
Despite the overhead resistance, there is sufficient pessimism in the market that, if unwound, can drive equity benchmarks through technical resistance areas as the recovery from the corrective lows continues. Both the SPY and iShares Russell 2000 ETF (IWM - 158.92) have experienced outflows since the beginning of February -- money that could come back into the market, representing demand as opposed to overhead supply.
And as I said two weeks ago, equity option buyers remain bearish, per the chart immediately below. Pessimism in this area of the market is around levels that have preceded rallies since early 2017, with the 10-day ratio of equity-only put buying relative to call buying far above the multi-year lows that occurred prior to the late-January/early February correction.
"With the long-term trend in the market still not broken, despite the recent correction, and the short-term sentiment backdrop pointing to room for improvement, there appears to be sufficient reward for bulls in exchange for the risk involved in taking on long positions with resistance lingering just above. That risk grows, however, if the VIX closes back above 18.30-18.66."
-- Monday Morning Outlook, Feb. 26, 2018
"With the VIX unable to topple 25 and, in fact, closing the week below 22.08, now might be a good time to bet on lower volatility in the days ahead."
-- Monday Morning Outlook, March 5, 2018
One prediction that proved precise last week was a bet on lower volatility. In fact, the VIX, even ahead of the employment number on Friday, experienced closes below the 18.30-18.66 area. This is a level that I discussed in detail two weeks ago, as 18.30 is double the 2018 closing low and 18.66 is one-half the 2018 closing high.
In another sign of fear, the "wrong-way" large speculators in the weekly Commitments of Traders (CoT) report are still net long volatility futures. This group has a long history of being on the wrong side of major volatility moves -- and, it should be noted, it is rare for this crowd to be long volatility futures, indicating that an unusual amount of pessimism is lingering... which again sets the stage for a surprise rally in stocks.
That said, VIX 13.72 is 50% above this year's closing low, and VIX traded south of here on Friday before closing the week at 14.64. Moreover, standard March VIX futures options expiration occurs on March 21, which is now less than two weeks away. With heavy put open interest in the 12 through 14 strikes, and heavy call open interest at 20 and above, it would not be surprising to see the VIX trading between 14 and 20 on the morning of March 21 settlement. This implies, from a very short-term perspective, that there may not be a lot left to the volatility decline we have seen since the highs earlier this month.
I still recommend a bullish bias, even with lingering resistance levels overhead on equity indexes and support just below on the VIX. March is favorable from a seasonality perspective, and there is the potential for an unwinding of negative sentiment after Friday's February employment data, on the heels of that January jobs report that so thoroughly rattled markets.
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